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The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that YRC Worldwide Inc. (NASDAQ:YRCW) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.
What Is YRC Worldwide’s Net Debt?
As you can see below, YRC Worldwide had US$874.2m of debt, at March 2019, which is about the same the year before. You can click the chart for greater detail. However, because it has a cash reserve of US$126.6m, its net debt is less, at about US$747.6m.
A Look At YRC Worldwide’s Liabilities
According to the last reported balance sheet, YRC Worldwide had liabilities of US$716.2m due within 12 months, and liabilities of US$1.56b due beyond 12 months. Offsetting these obligations, it had cash of US$126.6m as well as receivables valued at US$513.6m due within 12 months. So its liabilities total US$1.64b more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the US$124.8m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we’d watch its balance sheet closely, without a doubt At the end of the day, YRC Worldwide would probably need a major re-capitalization if its creditors were to demand repayment. Either way, since YRC Worldwide does have more debt than cash, it’s worth keeping an eye on its balance sheet.
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).
While YRC Worldwide’s debt to EBITDA ratio (3.00) suggests that it uses debt fairly modestly, its interest cover is very weak, at 0.92. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Given the debt load, it’s hardly ideal that YRC Worldwide’s EBIT was pretty flat over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if YRC Worldwide 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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, YRC Worldwide recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for and improvement.
To be frank both YRC Worldwide’s interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. Taking into account all the aforementioned factors, it looks like YRC Worldwide has too much debt. That sort of riskiness is ok for some, but it certainly doesn’t float our boat. While YRC Worldwide didn’t make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away.Click here to see if its earnings are heading in the right direction, over the medium term.
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 email@example.com. 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.