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.' 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. As with many other companies PolyOne Corporation (NYSE:POL) makes use of debt. But is this debt a concern to shareholders?
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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is PolyOne's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 PolyOne had US$1.42b of debt, an increase on US$1.33b, over one year. However, it does have US$125.5m in cash offsetting this, leading to net debt of about US$1.29b.
A Look At PolyOne's Liabilities
Zooming in on the latest balance sheet data, we can see that PolyOne had liabilities of US$607.3m due within 12 months and liabilities of US$1.75b due beyond that. Offsetting these obligations, it had cash of US$125.5m as well as receivables valued at US$473.8m due within 12 months. So it has liabilities totalling US$1.76b more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of US$2.39b. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
PolyOne has a debt to EBITDA ratio of 3.5 and its EBIT covered its interest expense 4.5 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Notably PolyOne's EBIT was pretty flat over the last year. Ideally it can diminish its debt load by kick-starting earnings growth. 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 PolyOne 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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, PolyOne recorded free cash flow worth 59% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Neither PolyOne's ability handle its debt, based on its EBITDA, nor its level of total liabilities gave us confidence in its ability to take on more debt. But it seems to be able to convert EBIT to free cash flow without much trouble. Taking the abovementioned factors together we do think PolyOne's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. Given our hesitation about the stock, it would be good to know if PolyOne insiders have sold any shares recently. You click here to find out if insiders have sold recently.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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