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Verizon Communications (NYSE:VZ) Takes On Some Risk With Its Use Of Debt

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Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about. 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. Importantly, Verizon Communications Inc. (NYSE:VZ) does carry debt. But the more important question is: how much risk is that debt creating?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Verizon Communications

What Is Verizon Communications's Debt?

You can click the graphic below for the historical numbers, but it shows that Verizon Communications had US$109.6b of debt in September 2019, down from US$114.3b, one year before. On the flip side, it has US$3.02b in cash leading to net debt of about US$106.6b.

NYSE:VZ Historical Debt, November 1st 2019
NYSE:VZ Historical Debt, November 1st 2019

How Healthy Is Verizon Communications's Balance Sheet?

The latest balance sheet data shows that Verizon Communications had liabilities of US$39.2b due within a year, and liabilities of US$185.4b falling due after that. Offsetting this, it had US$3.02b in cash and US$24.7b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$196.8b.

This is a mountain of leverage even relative to its gargantuan market capitalization of US$250.1b. 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).

With a debt to EBITDA ratio of 2.1, Verizon Communications uses debt artfully but responsibly. And the alluring interest cover (EBIT of 7.1 times interest expense) certainly does not do anything to dispel this impression. Verizon Communications grew its EBIT by 9.1% in the last year. That's far from incredible but it is a good thing, when it comes to paying off 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 Verizon Communications'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, Verizon Communications's free cash flow amounted to 40% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Verizon Communications's struggle to handle its total liabilities had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. But on the bright side, its ability to grow its EBIT isn't too shabby at all. Looking at all the angles mentioned above, it does seem to us that Verizon Communications is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares 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.

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 editorial-team@simplywallst.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.