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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 seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. As with many other companies. Worthington Industries, Inc. (NYSE:WOR) makes use of debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Worthington Industries Carry?
The chart below, which you can click on for greater detail, shows that Worthington Industries had US$749.3m in debt in May 2019; about the same as the year before. However, it also had US$92.4m in cash, and so its net debt is US$656.9m.
A Look At Worthington Industries’s Liabilities
We can see from the most recent balance sheet that Worthington Industries had liabilities of US$698.0m falling due within a year, and liabilities of US$864.4m due beyond that. Offsetting these obligations, it had cash of US$92.4m as well as receivables valued at US$512.8m due within 12 months. So it has liabilities totalling US$957.2m more than its cash and near-term receivables, combined.
This deficit isn’t so bad because Worthington Industries is worth US$2.23b, 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. Because it carries more debt than cash, we think it’s worth watching Worthington Industries’s balance sheet 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Worthington Industries has a debt to EBITDA ratio of 2.77 and its EBIT covered its interest expense 3.72 times. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. Even worse, Worthington Industries saw its EBIT tank 28% over the last 12 months. If earnings keep going like that over the long term, it has a snowball’s chance in hell of paying off that debt. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Worthington Industries’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Worthington Industries actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us excited like the crowd when the beat drops at a Daft Punk concert.
Neither Worthington Industries’s ability to grow its EBIT nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. Looking at all the angles mentioned above, it does seem to us that Worthington Industries is a somewhat risky investment as a result of its debt. That’s not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. In light of our reservations about the company’s balance sheet, it seems sensible to check if insiders have been selling shares recently.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.