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.' 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 note that Koppers Holdings Inc. (NYSE:KOP) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Koppers Holdings Carry?
As you can see below, Koppers Holdings had US$1.01b of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, it does have US$42.1m in cash offsetting this, leading to net debt of about US$965.1m.
A Look At Koppers Holdings's Liabilities
We can see from the most recent balance sheet that Koppers Holdings had liabilities of US$277.0m falling due within a year, and liabilities of US$1.22b due beyond that. On the other hand, it had cash of US$42.1m and US$214.6m worth of receivables due within a year. So it has liabilities totalling US$1.24b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the US$579.5m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt After all, Koppers Holdings would likely require a major re-capitalisation if it had to pay its creditors today.
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.
Weak interest cover of 2.0 times and a disturbingly high net debt to EBITDA ratio of 5.4 hit our confidence in Koppers Holdings like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Investors should also be troubled by the fact that Koppers Holdings saw its EBIT drop by 13% over the last twelve months. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Koppers Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Koppers Holdings created free cash flow amounting to 11% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.
To be frank both Koppers Holdings's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its EBIT growth rate fails to inspire much confidence. We think the chances that Koppers Holdings has too much debt a very significant. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. Given the risks around Koppers Holdings's use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
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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