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. As with many other companies Packaging Corporation of America (NYSE:PKG) makes use of debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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 Packaging of America Carry?
As you can see below, Packaging of America had US$2.49b 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$569.4m in cash offsetting this, leading to net debt of about US$1.92b.
How Healthy Is Packaging of America's Balance Sheet?
The latest balance sheet data shows that Packaging of America had liabilities of US$729.6m due within a year, and liabilities of US$3.42b falling due after that. Offsetting this, it had US$569.4m in cash and US$958.4m in receivables that were due within 12 months. So its liabilities total US$2.63b more than the combination of its cash and short-term receivables.
This deficit isn't so bad because Packaging of America is worth US$9.35b, 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Packaging of America's net debt is only 1.2 times its EBITDA. And its EBIT covers its interest expense a whopping 15.3 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also good is that Packaging of America grew its EBIT at 12% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Packaging of America 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Packaging of America recorded free cash flow worth 58% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Happily, Packaging of America's impressive interest cover implies it has the upper hand on its debt. And its EBIT growth rate is good too. All these things considered, it appears that Packaging of America can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Packaging of America insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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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