We Think NewMarket (NYSE:NEU) Is Taking Some Risk With Its Debt

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that NewMarket Corporation (NYSE:NEU) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

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What Is NewMarket's Debt?

The chart below, which you can click on for greater detail, shows that NewMarket had US$1.01b in debt in September 2022; about the same as the year before. However, because it has a cash reserve of US$72.0m, its net debt is less, at about US$936.5m.

How Healthy Is NewMarket's Balance Sheet?

According to the last reported balance sheet, NewMarket had liabilities of US$426.1m due within 12 months, and liabilities of US$1.24b due beyond 12 months. Offsetting this, it had US$72.0m in cash and US$476.1m in receivables that were due within 12 months. So it has liabilities totalling US$1.12b more than its cash and near-term receivables, combined.

NewMarket has a market capitalization of US$3.09b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

NewMarket's net debt of 2.4 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 9.1 times its interest expenses harmonizes with that theme. Sadly, NewMarket's EBIT actually dropped 2.5% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since NewMarket will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, NewMarket recorded free cash flow of 35% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Neither NewMarket's ability to convert EBIT to free cash flow nor its EBIT growth rate gave us confidence in its ability to take on more debt. But it seems to be able to cover its interest expense with its EBIT without much trouble. Looking at all the angles mentioned above, it does seem to us that NewMarket is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for NewMarket (of which 1 is potentially serious!) you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.