- Oops!Something went wrong.Please try again later.
The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Kaiser Aluminum Corporation (NASDAQ:KALU) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Kaiser Aluminum's Debt?
As you can see below, Kaiser Aluminum had US$370.9m of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, it also had US$146.8m in cash, and so its net debt is US$224.1m.
How Healthy Is Kaiser Aluminum's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Kaiser Aluminum had liabilities of US$178.9m due within 12 months and liabilities of US$496.9m due beyond that. Offsetting these obligations, it had cash of US$146.8m as well as receivables valued at US$250.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$278.9m.
Of course, Kaiser Aluminum has a market capitalization of US$1.51b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While Kaiser Aluminum's low debt to EBITDA ratio of 1.2 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.4 last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. But the other side of the story is that Kaiser Aluminum saw its EBIT decline by 3.7% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Kaiser Aluminum's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Kaiser Aluminum produced sturdy free cash flow equating to 53% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Kaiser Aluminum's conversion of EBIT to free cash flow was a real positive on this analysis, as was its net debt to EBITDA. On the other hand, its EBIT growth rate makes us a little less comfortable about its debt. Looking at all this data makes us feel a little cautious about Kaiser Aluminum's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Kaiser Aluminum's earnings per share history 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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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.