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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.' 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. 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?
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does West Fraser Timber Carry?
The chart below, which you can click on for greater detail, shows that West Fraser Timber had US$499.0m in debt in September 2021; about the same as the year before. However, its balance sheet shows it holds US$2.11b in cash, so it actually has US$1.61b net cash.
A Look At West Fraser Timber's Liabilities
According to the last reported balance sheet, West Fraser Timber had liabilities of US$1.28b due within 12 months, and liabilities of US$1.51b due beyond 12 months. Offsetting this, it had US$2.11b in cash and US$556.0m in receivables that were due within 12 months. So its liabilities total US$129.0m more than the combination of its cash and short-term receivables.
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$10.5b company is struggling for cash, we still think it's worth monitoring its balance sheet. While it does have liabilities worth noting, West Fraser Timber also has more cash than debt, so we're pretty confident it can manage its debt safely.
Better yet, West Fraser Timber grew its EBIT by 876% last year, which is an impressive improvement. 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're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept 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. During the last two years, West Fraser Timber generated free cash flow amounting to a very robust 86% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
We could understand if investors are concerned about West Fraser Timber's liabilities, but we can be reassured by the fact it has has net cash of US$1.61b. The cherry on top was that in converted 86% of that EBIT to free cash flow, bringing in US$3.3b. So we don't think West Fraser Timber's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with West Fraser Timber (at least 1 which is concerning) , and understanding them should be part of your investment process.
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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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.