Is Packaging Corporation of America (NYSE:PKG) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Packaging Corporation of America (NYSE:PKG) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Our analysis indicates that PKG is potentially undervalued!

What Is Packaging Corporation of America's Net Debt?

As you can see below, Packaging Corporation of America had US$2.47b of debt, at June 2022, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has US$749.6m in cash leading to net debt of about US$1.72b.

How Strong Is Packaging Corporation of America's Balance Sheet?

The latest balance sheet data shows that Packaging Corporation of America had liabilities of US$972.9m due within a year, and liabilities of US$3.40b falling due after that. Offsetting these obligations, it had cash of US$749.6m as well as receivables valued at US$1.21b due within 12 months. So its liabilities total US$2.41b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Packaging Corporation of America is worth a massive US$10.9b, and thus could probably raise enough capital to shore up 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 measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Packaging Corporation of America has a low net debt to EBITDA ratio of only 0.87. And its EBIT covers its interest expense a whopping 18.6 times over. So we're pretty relaxed about its super-conservative use of debt. In addition to that, we're happy to report that Packaging Corporation of America has boosted its EBIT by 56%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Packaging Corporation of America can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Packaging Corporation of America produced sturdy free cash flow equating to 51% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

The good news is that Packaging Corporation of America's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its EBIT growth rate also supports that impression! Looking at the bigger picture, we think Packaging Corporation of America's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Packaging Corporation of America (at least 1 which can't be ignored) , and understanding them should be part of your investment process.

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.