The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. We can see that HollyFrontier Corporation (NYSE:HFC) does use debt in its business. But the more important question is: how much risk is that debt creating?
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. If things get really bad, the lenders can take control of the business. 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.
What Is HollyFrontier's Debt?
As you can see below, HollyFrontier had US$2.47b of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, it does have US$914.6m in cash offsetting this, leading to net debt of about US$1.55b.
How Strong Is HollyFrontier's Balance Sheet?
We can see from the most recent balance sheet that HollyFrontier had liabilities of US$1.66b falling due within a year, and liabilities of US$3.91b due beyond that. On the other hand, it had cash of US$914.6m and US$863.9m worth of receivables due within a year. So it has liabilities totalling US$3.79b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since HollyFrontier has a market capitalization of US$7.62b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
HollyFrontier's net debt is only 0.74 times its EBITDA. And its EBIT easily covers its interest expense, being 14.0 times the size. So we're pretty relaxed about its super-conservative use of debt. On the other hand, HollyFrontier saw its EBIT drop by 7.0% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if HollyFrontier can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
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. During the last three years, HollyFrontier produced sturdy free cash flow equating to 77% 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.
HollyFrontier's interest cover was a real positive on this analysis, as was its conversion of EBIT to free cash flow. Having said that, its EBIT growth rate somewhat sensitizes us to potential future risks to the balance sheet. Considering this range of data points, we think HollyFrontier is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that HollyFrontier insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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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