Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 note that John Wood Group PLC (LON:WG.) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
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. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is John Wood Group's Debt?
As you can see below, John Wood Group had US$2.94b of debt, at December 2018, which is about the same the year before. You can click the chart for greater detail. However, it does have US$1.35b in cash offsetting this, leading to net debt of about US$1.58b.
How Healthy Is John Wood Group's Balance Sheet?
We can see from the most recent balance sheet that John Wood Group had liabilities of US$3.87b falling due within a year, and liabilities of US$3.27b due beyond that. Offsetting these obligations, it had cash of US$1.35b as well as receivables valued at US$2.44b due within 12 months. So its liabilities total US$3.35b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of US$4.19b. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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).
John Wood Group's debt is 3.0 times its EBITDA, and its EBIT cover its interest expense 3.2 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. The good news is that John Wood Group grew its EBIT a smooth 76% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing 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 John Wood Group'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, John Wood Group recorded free cash flow worth a fulsome 89% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
John Wood Group's conversion of EBIT to free cash flow was a real positive on this analysis, as was its EBIT growth rate. On the other hand, its interest cover makes us a little less comfortable about its debt. Considering this range of data points, we think John Wood Group is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. We'd be motivated to research the stock further if we found out that John Wood Group 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, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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