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. 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 Magna International Inc. (TSE:MG) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Magna International's Debt?
As you can see below, Magna International had US$3.56b of debt at September 2019, down from US$4.63b a year prior. However, because it has a cash reserve of US$769.0m, its net debt is less, at about US$2.79b.
A Look At Magna International's Liabilities
We can see from the most recent balance sheet that Magna International had liabilities of US$9.52b falling due within a year, and liabilities of US$5.92b due beyond that. Offsetting these obligations, it had cash of US$769.0m as well as receivables valued at US$7.09b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$7.58b.
While this might seem like a lot, it is not so bad since Magna International has a huge market capitalization of US$17.0b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Magna International has a low net debt to EBITDA ratio of only 0.69. And its EBIT covers its interest expense a whopping 28.2 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, Magna International's EBIT dived 13%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 Magna International'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. 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, Magna International recorded free cash flow worth 73% 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.
Both Magna International's ability to to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. But truth be told its EBIT growth rate had us nibbling our nails. When we consider all the elements mentioned above, it seems to us that Magna International is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. We'd be motivated to research the stock further if we found out that Magna International 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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.