David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. Importantly, Warner Music Group Corp. (NASDAQ:WMG) does carry debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Warner Music Group's Debt?
The image below, which you can click on for greater detail, shows that at June 2023 Warner Music Group had debt of US$3.99b, up from US$3.79b in one year. On the flip side, it has US$607.0m in cash leading to net debt of about US$3.38b.
How Strong Is Warner Music Group's Balance Sheet?
We can see from the most recent balance sheet that Warner Music Group had liabilities of US$3.29b falling due within a year, and liabilities of US$4.56b due beyond that. On the other hand, it had cash of US$607.0m and US$1.11b worth of receivables due within a year. So it has liabilities totalling US$6.13b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Warner Music Group has a huge market capitalization of US$16.2b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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).
Warner Music Group has a debt to EBITDA ratio of 3.1 and its EBIT covered its interest expense 5.6 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. One way Warner Music Group could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 17%, as it did over the last year. 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 Warner Music Group 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. In the last three years, Warner Music Group's free cash flow amounted to 38% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
When it comes to the balance sheet, the standout positive for Warner Music Group was the fact that it seems able to grow its EBIT confidently. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit handle its debt, based on its EBITDA,. Looking at all this data makes us feel a little cautious about Warner Music Group's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. Case in point: We've spotted 2 warning signs for Warner Music Group you should be aware of, and 1 of them is a bit concerning.
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.
What are the risks and opportunities for Warner Music Group?
Trading at 20.4% below our estimate of its fair value
Earnings are forecast to grow 18.01% per year
Debt is not well covered by operating cash flow
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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.