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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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Kansas City Southern (NYSE:KSU) does have debt on its balance sheet. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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, 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 Kansas City Southern Carry?
As you can see below, Kansas City Southern had US$2.69b of debt, at March 2019, which is about the same the year before. You can click the chart for greater detail. However, it does have US$92.7m in cash offsetting this, leading to net debt of about US$2.59b.
A Look At Kansas City Southern’s Liabilities
The latest balance sheet data shows that Kansas City Southern had liabilities of US$480.6m due within a year, and liabilities of US$4.01b falling due after that. Offsetting these obligations, it had cash of US$92.7m as well as receivables valued at US$277.9m due within 12 months. So it has liabilities totalling US$4.12b more than its cash and near-term receivables, combined.
Kansas City Southern has a very large market capitalization of US$12.1b, so it could very likely ameliorate its balance sheet if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. Since Kansas City Southern does have net debt, we think it is worthwhile for shareholders to keep an eye on the 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). 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’s net debt of 1.95 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 8.67 times its interest expenses harmonizes with that theme. We saw Kansas City Southern grow its EBIT by 5.2% in the last twelve months. That’s far from incredible but it is a good thing, when it comes to paying off debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Kansas City Southern’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
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 41% of its EBIT, which is weaker than we’d expect. That’s not great, when it comes to paying down debt.
On our analysis Kansas City Southern’s interest cover should signal that it won’t have too much trouble with its debt. But the other factors we noted above weren’t so encouraging. For instance it seems like it has to struggle a bit to convert EBIT to free cash flow. 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. We’d be motivated to research the stock further if we found out that Kansas City Southern insiders have bought shares recently. If you would too, then you’re in luck, since today we’re sharing our list of reported insider transactions for free.
At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
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.