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 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. As with many other companies AK Steel Holding Corporation (NYSE:AKS) makes use of debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does AK Steel Holding Carry?
As you can see below, AK Steel Holding had US$1.95b of debt at June 2019, down from US$2.04b a year prior. However, it also had US$42.2m in cash, and so its net debt is US$1.90b.
How Healthy Is AK Steel Holding's Balance Sheet?
According to the last reported balance sheet, AK Steel Holding had liabilities of US$1.07b due within 12 months, and liabilities of US$3.14b due beyond 12 months. Offsetting these obligations, it had cash of US$42.2m as well as receivables valued at US$675.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$3.49b.
The deficiency here weighs heavily on the US$724.5m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, AK Steel Holding would likely require a major re-capitalisation if it had to pay its creditors today.
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.
AK Steel Holding's debt is 2.8 times its EBITDA, and its EBIT cover its interest expense 2.8 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. The good news is that AK Steel Holding grew its EBIT a smooth 44% over the last twelve months. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its 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 AK Steel Holding'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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. In the last three years, AK Steel Holding's free cash flow amounted to 21% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
We'd go so far as to say AK Steel Holding's level of total liabilities was disappointing. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Overall, we think it's fair to say that AK Steel Holding has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. Given our hesitation about the stock, it would be good to know if AK Steel Holding insiders have sold any shares recently. You click here to find out if insiders have sold recently.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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.