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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Covanta Holding Corporation (NYSE:CVA) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.
What Is Covanta Holding's Debt?
The chart below, which you can click on for greater detail, shows that Covanta Holding had US$2.51b in debt in June 2019; about the same as the year before. However, because it has a cash reserve of US$102.0m, its net debt is less, at about US$2.41b.
How Strong Is Covanta Holding's Balance Sheet?
We can see from the most recent balance sheet that Covanta Holding had liabilities of US$405.0m falling due within a year, and liabilities of US$3.08b due beyond that. On the other hand, it had cash of US$102.0m and US$340.0m worth of receivables due within a year. So it has liabilities totalling US$3.04b more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company's US$2.25b market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner's social media. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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). 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).
Weak interest cover of 0.64 times and a disturbingly high net debt to EBITDA ratio of 7.8 hit our confidence in Covanta Holding like a one-two punch to the gut. The debt burden here is substantial. Another concern for investors might be that Covanta Holding's EBIT fell 19% in the last year. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Covanta Holding 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Covanta Holding created free cash flow amounting to 14% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
On the face of it, Covanta Holding's net debt to EBITDA left us tentative about the stock, and its interest cover was no more enticing than the one empty restaurant on the busiest night of the year. And even its level of total liabilities fails to inspire much confidence. We think the chances that Covanta Holding has too much debt a very significant. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. Given our concerns about Covanta Holding's debt levels, it seems only prudent to check if insiders have been ditching the stock.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.