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.' 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 note that The Goodyear Tire & Rubber Company (NASDAQ:GT) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Goodyear Tire & Rubber's Net Debt?
The chart below, which you can click on for greater detail, shows that Goodyear Tire & Rubber had US$6.49b in debt in June 2019; about the same as the year before. However, it also had US$917.0m in cash, and so its net debt is US$5.57b.
How Strong Is Goodyear Tire & Rubber's Balance Sheet?
We can see from the most recent balance sheet that Goodyear Tire & Rubber had liabilities of US$5.08b falling due within a year, and liabilities of US$8.34b due beyond that. On the other hand, it had cash of US$917.0m and US$2.45b worth of receivables due within a year. So it has liabilities totalling US$10.1b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the US$2.55b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt After all, Goodyear Tire & Rubber would likely require a major re-capitalisation if it had to pay its creditors today.
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). 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).
Goodyear Tire & Rubber has a debt to EBITDA ratio of 3.4 and its EBIT covered its interest expense 2.6 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Even worse, Goodyear Tire & Rubber saw its EBIT tank 29% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. 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 Goodyear Tire & Rubber 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Goodyear Tire & Rubber's free cash flow amounted to 21% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
On the face of it, Goodyear Tire & Rubber's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its conversion of EBIT to free cash flow also fails to instill confidence. Taking into account all the aforementioned factors, it looks like Goodyear Tire & Rubber has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. Given our concerns about Goodyear Tire & Rubber's debt levels, it seems only prudent to check if insiders have been ditching the stock.
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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