Southwest Airlines (NYSE:LUV) Seems To Use Debt Quite Sensibly

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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. As with many other companies Southwest Airlines Co. (NYSE:LUV) makes use of debt. But should shareholders be worried about its use of debt?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

See our latest analysis for Southwest Airlines

What Is Southwest Airlines's Debt?

The image below, which you can click on for greater detail, shows that Southwest Airlines had debt of US$10.5b at the end of June 2022, a reduction from US$11.4b over a year. But on the other hand it also has US$16.4b in cash, leading to a US$5.89b net cash position.

How Healthy Is Southwest Airlines' Balance Sheet?

According to the last reported balance sheet, Southwest Airlines had liabilities of US$11.7b due within 12 months, and liabilities of US$15.5b due beyond 12 months. Offsetting these obligations, it had cash of US$16.4b as well as receivables valued at US$1.39b due within 12 months. So its liabilities total US$9.36b more than the combination of its cash and short-term receivables.

Southwest Airlines has a very large market capitalization of US$19.2b, so it could very likely raise cash to 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. Despite its noteworthy liabilities, Southwest Airlines boasts net cash, so it's fair to say it does not have a heavy debt load!

We also note that Southwest Airlines improved its EBIT from a last year's loss to a positive US$1.3b. 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 Southwest Airlines'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. While Southwest Airlines has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last year, Southwest Airlines produced sturdy free cash flow equating to 65% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

Although Southwest Airlines's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$5.89b. So we don't have any problem with Southwest Airlines's use of debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Southwest Airlines you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.