Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Worthington Industries, Inc. (NYSE:WOR) does carry debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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.
What Is Worthington Industries's Net Debt?
The chart below, which you can click on for greater detail, shows that Worthington Industries had US$749.3m in debt in May 2019; about the same as the year before. However, it does have US$92.4m in cash offsetting this, leading to net debt of about US$656.9m.
How Strong Is Worthington Industries's Balance Sheet?
We can see from the most recent balance sheet that Worthington Industries had liabilities of US$698.0m falling due within a year, and liabilities of US$864.4m due beyond that. Offsetting these obligations, it had cash of US$92.4m as well as receivables valued at US$510.5m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$959.6m.
Worthington Industries has a market capitalization of US$2.21b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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).
Worthington Industries has a debt to EBITDA ratio of 2.8 and its EBIT covered its interest expense 3.7 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Worse, Worthington Industries's EBIT was down 28% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. 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 Worthington Industries 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Worthington Industries 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.
Neither Worthington Industries's ability to grow its EBIT nor its interest cover gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. We think that Worthington Industries's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. Given our hesitation about the stock, it would be good to know if Worthington Industries insiders have sold any shares recently. You click here to find out if insiders have sold recently.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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