Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Domtar Corporation (NYSE:UFS) does have debt on its balance sheet. 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. If things get really bad, the lenders can take control of the business. 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 step when considering a company's debt levels is to consider its cash and debt together.
What Is Domtar's Net Debt?
The image below, which you can click on for greater detail, shows that Domtar had debt of US$930.0m at the end of September 2019, a reduction from US$1.10b over a year. However, it also had US$98.0m in cash, and so its net debt is US$832.0m.
A Look At Domtar's Liabilities
Zooming in on the latest balance sheet data, we can see that Domtar had liabilities of US$702.0m due within 12 months and liabilities of US$1.74b due beyond that. Offsetting these obligations, it had cash of US$98.0m as well as receivables valued at US$671.0m due within 12 months. So its liabilities total US$1.68b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of US$2.19b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). 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).
Domtar has net debt of just 1.2 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 8.2 times, which is more than adequate. In addition to that, we're happy to report that Domtar has boosted its EBIT by 32%, thus reducing the spectre of future debt repayments. 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 Domtar 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, 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. During the last three years, Domtar generated free cash flow amounting to a very robust 87% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
The good news is that Domtar's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its level of total liabilities. Taking all this data into account, it seems to us that Domtar takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. We'd be motivated to research the stock further if we found out that Domtar 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.
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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