Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We note that Vulcan Materials Company (NYSE:VMC) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Vulcan Materials's Debt?
The chart below, which you can click on for greater detail, shows that Vulcan Materials had US$2.79b in debt in March 2021; about the same as the year before. However, it also had US$722.3m in cash, and so its net debt is US$2.07b.
How Healthy Is Vulcan Materials' Balance Sheet?
The latest balance sheet data shows that Vulcan Materials had liabilities of US$565.9m due within a year, and liabilities of US$4.63b falling due after that. Offsetting these obligations, it had cash of US$722.3m as well as receivables valued at US$593.1m due within 12 months. So it has liabilities totalling US$3.88b more than its cash and near-term receivables, combined.
Given Vulcan Materials has a humongous market capitalization of US$23.8b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Vulcan Materials's net debt is sitting at a very reasonable 1.6 times its EBITDA, while its EBIT covered its interest expense just 6.8 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. The good news is that Vulcan Materials has increased its EBIT by 4.1% over twelve months, which should ease any concerns about debt repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Vulcan Materials can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Vulcan Materials produced sturdy free cash flow equating to 69% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Happily, Vulcan Materials's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And its interest cover is good too. All these things considered, it appears that Vulcan Materials can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 1 warning sign for Vulcan Materials that you should be aware of.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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