These 4 Measures Indicate That Venator Materials (NYSE:VNTR) Is Using Debt In A Risky Way

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Venator Materials PLC (NYSE:VNTR) does carry debt. But the real question is whether this debt is making the company risky.

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. 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.

See our latest analysis for Venator Materials

What Is Venator Materials's Net Debt?

As you can see below, Venator Materials had US$967.0m of debt, at March 2022, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of US$46.0m, its net debt is less, at about US$921.0m.

How Healthy Is Venator Materials' Balance Sheet?

According to the last reported balance sheet, Venator Materials had liabilities of US$518.0m due within 12 months, and liabilities of US$1.28b due beyond 12 months. On the other hand, it had cash of US$46.0m and US$489.0m worth of receivables due within a year. So it has liabilities totalling US$1.26b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the US$278.4m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Venator Materials would likely require a major re-capitalisation if it had to pay its creditors today.

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.

Venator Materials shareholders face the double whammy of a high net debt to EBITDA ratio (6.5), and fairly weak interest coverage, since EBIT is just 0.41 times the interest expense. This means we'd consider it to have a heavy debt load. However, the silver lining was that Venator Materials achieved a positive EBIT of US$24m in the last twelve months, an improvement on the prior year's loss. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Venator Materials 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Venator Materials saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Venator Materials's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least its EBIT growth rate is not so bad. We think the chances that Venator Materials has too much debt a very significant. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Venator Materials is showing 2 warning signs in our investment analysis , you should know about...

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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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.