Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say this when he says “The biggest risk in investing is not price volatility, but if you will suffer a loss. permanent capital “. So it seems like smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess the level of risk of a business. We can see that WestRock Company (NYSE: WRK) uses debt in its business. But should shareholders be concerned about its use of debt?
When is Debt a Problem?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it exists at their mercy. In the worst case scenario, a business can go bankrupt if it cannot pay its creditors. However, a more common (but still costly) situation is where a company has to dilute its shareholders at a cheap share price just to get its debt under control. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. When we think of a business’s use of debt, we first look at cash flow and debt together.
What is WestRock’s net debt?
The image below, which you can click for more details, shows that WestRock was in debt of $ 7.93 billion at the end of September 2021, a reduction from $ 9.16 billion. over a year. On the other hand, it has $ 290.9 million in cash, resulting in net debt of around $ 7.64 billion.
NYSE: WRK Debt to Equity History December 21, 2021
Is WestRock’s Balance Sheet Healthy?
We can see from the most recent balance sheet that WestRock had liabilities of US $ 3.64 billion maturing within one year and liabilities of US $ 13.9 billion maturing beyond that. In return, he had $ 290.9 million in cash and $ 2.79 billion in receivables due within 12 months. Its liabilities therefore total $ 14.5 billion more than the combination of its cash and short-term receivables.
Given that this deficit is actually greater than the company’s massive market cap of $ 11.2 billion, we think shareholders should really watch WestRock’s debt levels, like a parent watching their child do. cycling for the first time. Hypothetically, extremely high dilution would be required if the company were forced to repay its debts by raising capital at the current share price.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its earnings before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). Thus, we consider debt versus earnings with and without amortization expenses.
WestRock has a debt to EBITDA ratio of 2.6 and its EBIT covered interest expense 3.9 times. This suggests that while debt levels are significant, we would stop calling them problematic. On a slightly more positive note, WestRock has increased its EBIT to 16% over the past year, further increasing its ability to manage debt. When analyzing debt levels, the balance sheet is the obvious place to start. But ultimately, the company’s future profitability will decide whether WestRock can strengthen its balance sheet over time. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
Finally, while the IRS may love accounting profits, lenders only accept hard cash. We must therefore clearly examine whether this EBIT leads to the corresponding free cash flow. Over the past three years, WestRock has recorded free cash flow totaling 83% of its EBIT, which is higher than what we normally expected. This positions it well to repay debt if it is desirable.
Our point of view
WestRock’s level of total liabilities and interest coverage certainly weighs on this, in our view. But its conversion from EBIT to free cash flow tells a very different story and suggests some resilience. We think WestRock’s debt makes it a bit risky, having looked at the aforementioned data points together. Not all risks are bad, as they can increase stock returns if they are profitable, but this risk of leverage is worth keeping in mind. The balance sheet is clearly the area to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist off the balance sheet. Be aware that WestRock shows 3 warning signs in our investment analysis , you must know…
At the end of the day, it’s often best to focus on businesses that don’t have net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.
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