Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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 The Weir Group PLC (LON:WEIR) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.
How Much Debt Does Weir Group Carry?
The image below, which you can click on for greater detail, shows that at June 2019 Weir Group had debt of UK£1.81b, up from UK£1.20b in one year. However, it also had UK£499.0m in cash, and so its net debt is UK£1.31b.
A Look At Weir Group's Liabilities
We can see from the most recent balance sheet that Weir Group had liabilities of UK£957.6m falling due within a year, and liabilities of UK£1.77b due beyond that. On the other hand, it had cash of UK£499.0m and UK£643.8m worth of receivables due within a year. So its liabilities total UK£1.59b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Weir Group has a market capitalization of UK£3.31b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With net debt to EBITDA of 3.0 Weir Group has a fairly noticeable amount of debt. But the high interest coverage of 7.0 suggests it can easily service that debt. Weir Group grew its EBIT by 2.4% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Weir Group's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Weir Group recorded free cash flow of 24% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
While Weir Group's net debt to EBITDA makes us cautious about it, its track record of converting EBIT to free cash flow is no better. But its not so bad at covering its interest expense with its EBIT. We think that Weir Group's debt does make it a bit risky, after considering the aforementioned data points together. 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. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Weir Group's dividend history, without delay!
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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