David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital. 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. We can see that ONEOK, Inc. (NYSE:OKE) does use debt in its business. But should shareholders be worried about its use of debt?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.
How Much Debt Does ONEOK Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 ONEOK had US$11.3b of debt, an increase on US$8.19b, over one year. However, it also had US$273.4m in cash, and so its net debt is US$11.0b.
How Strong Is ONEOK's Balance Sheet?
We can see from the most recent balance sheet that ONEOK had liabilities of US$1.74b falling due within a year, and liabilities of US$11.7b due beyond that. Offsetting these obligations, it had cash of US$273.4m as well as receivables valued at US$670.6m due within 12 months. So its liabilities total US$12.5b more than the combination of its cash and short-term receivables.
This deficit isn't so bad because ONEOK is worth a massive US$29.7b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
ONEOK has a debt to EBITDA ratio of 4.7 and its EBIT covered its interest expense 4.0 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. However, one redeeming factor is that ONEOK grew its EBIT at 18% over the last 12 months, boosting its ability to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine ONEOK'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 always check how much of that EBIT is translated into free cash flow. In the last three years, ONEOK created free cash flow amounting to 13% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.
While ONEOK's conversion of EBIT to free cash flow makes us cautious about it, its track record of managing its debt, based on its EBITDA, is no better. But its not so bad at growing its EBIT. Taking the abovementioned factors together we do think ONEOK's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. Given ONEOK 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.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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