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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.' 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. We can see that West Fraser Timber Co. Ltd. (TSE:WFG) does use debt in its business. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
What Is West Fraser Timber's Net Debt?
The image below, which you can click on for greater detail, shows that West Fraser Timber had debt of US$499.0m at the end of June 2021, a reduction from US$771.9m over a year. However, it does have US$2.23b in cash offsetting this, leading to net cash of US$1.73b.
How Healthy Is West Fraser Timber's Balance Sheet?
The latest balance sheet data shows that West Fraser Timber had liabilities of US$1.28b due within a year, and liabilities of US$1.60b falling due after that. Offsetting these obligations, it had cash of US$2.23b as well as receivables valued at US$799.0m due within 12 months. So it actually has US$158.0m more liquid assets than total liabilities.
This state of affairs indicates that West Fraser Timber's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the US$8.43b company is struggling for cash, we still think it's worth monitoring its balance sheet. Succinctly put, West Fraser Timber boasts net cash, so it's fair to say it does not have a heavy debt load!
Even more impressive was the fact that West Fraser Timber grew its EBIT by 54,330% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. 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 West Fraser Timber can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. West Fraser Timber may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, West Fraser Timber recorded free cash flow worth 77% 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.
While it is always sensible to investigate a company's debt, in this case West Fraser Timber has US$1.73b in net cash and a decent-looking balance sheet. And it impressed us with its EBIT growth of 54,330% over the last year. So we don't think West Fraser Timber's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example - West Fraser Timber has 2 warning signs we think you should be aware of.
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.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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