Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Waste Connections, Inc. (NYSE:WCN) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Waste Connections Carry?
As you can see below, Waste Connections had US$4.95b of debt, at September 2021, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has US$339.5m in cash leading to net debt of about US$4.61b.
How Strong Is Waste Connections’ Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Waste Connections had liabilities of US$1.15b due within 12 months and liabilities of US$6.25b due beyond that. On the other hand, it had cash of US$339.5m and US$692.1m worth of receivables due within a year. So its liabilities total US$6.36b more than the combination of its cash and short-term receivables.
Since publicly traded Waste Connections shares are worth a very impressive total of US$35.5b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse.
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).
Waste Connections has a debt to EBITDA ratio of 2.5 and its EBIT covered its interest expense 6.3 times. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. One way Waste Connections could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 16%, as it did over the last year. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Waste Connections’s ability to maintain a healthy balance sheet going forward.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Waste Connections recorded free cash flow worth a fulsome 92% of its EBIT, which is stronger than we’d usually expect. That positions it well to pay down debt if desirable to do so.
Our View
The good news is that Waste Connections’s demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its net debt to EBITDA. Taking all this data into account, it seems to us that Waste Connections takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. When analysing debt levels, the balance sheet is the obvious place to start.