Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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, Kansas City Southern (NYSE:KSU) does carry debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Kansas City Southern Carry?
As you can see below, at the end of December 2020, Kansas City Southern had US$3.76b of debt, up from US$3.24b a year ago. Click the image for more detail. However, it also had US$188.2m in cash, and so its net debt is US$3.58b.
How Strong Is Kansas City Southern's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Kansas City Southern had liabilities of US$476.4m due within 12 months and liabilities of US$5.10b due beyond that. On the other hand, it had cash of US$188.2m and US$247.1m worth of receivables due within a year. So its liabilities total US$5.15b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Kansas City Southern has a huge market capitalization of US$20.4b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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).
Kansas City Southern has a debt to EBITDA ratio of 2.6 and its EBIT covered its interest expense 6.9 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Notably Kansas City Southern's EBIT was pretty flat over the last year. Ideally it can diminish its debt load by kick-starting earnings growth. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Kansas City Southern 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Kansas City Southern recorded free cash flow of 46% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Kansas City Southern's interest cover was a real positive on this analysis, as was its level of total liabilities. On the other hand, its net debt to EBITDA makes us a little less comfortable about its debt. When we consider all the factors mentioned above, we do feel a bit cautious about Kansas City Southern's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. To that end, you should be aware of the 1 warning sign we've spotted with Kansas City Southern .
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.
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