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. We can see that PPL Corporation (NYSE:PPL) does use debt in its business. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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 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. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does PPL Carry?
The chart below, which you can click on for greater detail, shows that PPL had US$22.8b in debt in June 2019; about the same as the year before. Net debt is about the same, since the it doesn't have much cash.
How Healthy Is PPL's Balance Sheet?
We can see from the most recent balance sheet that PPL had liabilities of US$4.06b falling due within a year, and liabilities of US$28.2b due beyond that. Offsetting these obligations, it had cash of US$406.0m as well as receivables valued at US$1.20b due within 12 months. So it has liabilities totalling US$30.6b more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's massive market capitalization of US$21.3b, we think shareholders really should watch PPL's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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.
With a net debt to EBITDA ratio of 5.2, it's fair to say PPL does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 3.2 times, suggesting it can responsibly service its obligations. Even more troubling is the fact that PPL actually let its EBIT decrease by 4.6% over the last year. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. 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 PPL 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. Considering the last three years, PPL 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.
To be frank both PPL's level of total liabilities and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. And furthermore, its interest cover also fails to instill confidence. We should also note that Electric Utilities industry companies like PPL commonly do use debt without problems. After considering the datapoints discussed, we think PPL has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. Given PPL has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
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.
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