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. 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 BCE Inc. (TSE:BCE) 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 and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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 BCE's Debt?
The chart below, which you can click on for greater detail, shows that BCE had CA$25.1b in debt in September 2019; about the same as the year before. However, it does have CA$966.0m in cash offsetting this, leading to net debt of about CA$24.1b.
How Healthy Is BCE's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that BCE had liabilities of CA$10.4b due within 12 months and liabilities of CA$29.0b due beyond that. On the other hand, it had cash of CA$966.0m and CA$3.92b worth of receivables due within a year. So it has liabilities totalling CA$34.5b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since BCE has a huge market capitalization of CA$58.2b, 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.
BCE's debt is 2.6 times its EBITDA, and its EBIT cover its interest expense 5.1 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. BCE grew its EBIT by 3.6% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine BCE'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, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, BCE recorded free cash flow worth 65% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
When it comes to the balance sheet, the standout positive for BCE was the fact that it seems able to convert EBIT to free cash flow confidently. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit to handle its total liabilities. When we consider all the factors mentioned above, we do feel a bit cautious about BCE's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. We'd be motivated to research the stock further if we found out that BCE insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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