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Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies. Black Hills Corporation (NYSE:BKH) makes use of debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Black Hills Carry?
You can click the graphic below for the historical numbers, but it shows that Black Hills had US$3.12b of debt in March 2019, down from US$3.28b, one year before Net debt is about the same, since the it doesn’t have much cash.
How Strong Is Black Hills’s Balance Sheet?
The latest balance sheet data shows that Black Hills had liabilities of US$591.0m due within a year, and liabilities of US$4.06b falling due after that. Offsetting this, it had US$12.2m in cash and US$297.9m in receivables that were due within 12 months. So its liabilities total US$4.34b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of US$4.72b. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry. Since Black Hills does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, over time.
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). 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).
Black Hills has a rather high debt to EBITDA ratio of 5.14 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 2.84 times, suggesting it can responsibly service its obligations. Even more troubling is the fact that Black Hills actually let its EBIT decrease by 2.2% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its debt. 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 Black Hills can strengthen its balance sheet over time. 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 always check how much of that EBIT is translated into free cash flow. Considering the last three years, Black Hills actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
On the face of it, Black Hills’s conversion of EBIT to free cash flow left us tentative about the stock, and its net debt to EBITDA was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to grow its EBIT isn’t such a worry. We should also note that Integrated Utilities industry companies like Black Hills commonly do use debt without problems. Overall, it seems to us that Black Hills’s debt load is really quite a risk to the business. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on the balance sheet . Given our hesitation about the stock, it would be good to know if Black Hills insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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