Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Western Digital Corporation (NASDAQ:WDC) makes use of debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is Western Digital's Net Debt?
The image below, which you can click on for greater detail, shows that Western Digital had debt of US$10.5b at the end of June 2019, a reduction from US$11.2b over a year. However, it does have US$3.46b in cash offsetting this, leading to net debt of about US$7.07b.
How Healthy Is Western Digital's Balance Sheet?
According to the last reported balance sheet, Western Digital had liabilities of US$3.82b due within 12 months, and liabilities of US$12.6b due beyond 12 months. Offsetting these obligations, it had cash of US$3.46b as well as receivables valued at US$1.20b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$11.7b.
This is a mountain of leverage even relative to its gargantuan market capitalization of US$16.3b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). 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).
While we wouldn't worry about Western Digital's net debt to EBITDA ratio of 3.4, we think its super-low interest cover of 0.72 times is a sign of high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Worse, Western Digital's EBIT was down 93% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 Western Digital 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. Happily for any shareholders, Western Digital actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
To be frank both Western Digital's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Western Digital stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. While Western Digital didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away.Click here to see if its earnings are heading in the right direction, over the medium term.
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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