Is Union Pacific (NYSE:UNP) A Risky Investment?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. Importantly, Union Pacific Corporation (NYSE:UNP) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Union Pacific

How Much Debt Does Union Pacific Carry?

As you can see below, at the end of March 2023, Union Pacific had US$33.6b of debt, up from US$31.9b a year ago. Click the image for more detail. However, because it has a cash reserve of US$1.08b, its net debt is less, at about US$32.5b.

How Healthy Is Union Pacific's Balance Sheet?

According to the last reported balance sheet, Union Pacific had liabilities of US$6.21b due within 12 months, and liabilities of US$47.3b due beyond 12 months. On the other hand, it had cash of US$1.08b and US$1.96b worth of receivables due within a year. So its liabilities total US$50.5b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Union Pacific has a huge market capitalization of US$125.8b, 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 measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Union Pacific has net debt to EBITDA of 2.7 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 7.5 suggests it can easily service that debt. Importantly Union Pacific's EBIT was essentially flat over the last twelve months. We would prefer to see some earnings growth, because that always helps diminish 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 Union Pacific'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Union Pacific produced sturdy free cash flow equating to 63% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Both Union Pacific's ability to to convert EBIT to free cash flow and its interest cover gave us comfort that it can handle its debt. Having said that, its net debt to EBITDA somewhat sensitizes us to potential future risks to the balance sheet. When we consider all the factors mentioned above, we do feel a bit cautious about Union Pacific's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. To that end, you should be aware of the 1 warning sign we've spotted with Union Pacific .

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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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.