Is Norfolk Southern (NYSE:NSC) A Risky Investment?

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 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 Norfolk Southern Corporation (NYSE:NSC) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Norfolk Southern

What Is Norfolk Southern's Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Norfolk Southern had debt of US$17.1b, up from US$15.6b in one year. However, because it has a cash reserve of US$1.51b, its net debt is less, at about US$15.6b.

How Strong Is Norfolk Southern's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Norfolk Southern had liabilities of US$2.91b due within 12 months and liabilities of US$25.2b due beyond that. On the other hand, it had cash of US$1.51b and US$1.21b worth of receivables due within a year. So it has liabilities totalling US$25.4b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Norfolk Southern is worth a massive US$51.8b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Norfolk Southern's debt is 3.3 times its EBITDA, and its EBIT cover its interest expense 4.9 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Shareholders should be aware that Norfolk Southern's EBIT was down 29% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 Norfolk 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Norfolk Southern recorded free cash flow worth 51% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

We'd go so far as to say Norfolk Southern's EBIT growth rate was disappointing. But at least its conversion of EBIT to free cash flow is not so bad. Once we consider all the factors above, together, it seems to us that Norfolk Southern's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Norfolk Southern (at least 1 which is concerning) , and understanding them should be part of your investment process.

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.