Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ 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. We note that Baker Hughes Company (NASDAQ:BKR) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Baker Hughes’s Debt?
As you can see below, Baker Hughes had US$6.73b of debt, at December 2022, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has US$3.24b in cash leading to net debt of about US$3.49b.
How Strong Is Baker Hughes’ Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Baker Hughes had liabilities of US$11.1b due within 12 months and liabilities of US$8.58b due beyond that. Offsetting these obligations, it had cash of US$3.24b as well as receivables valued at US$5.96b due within 12 months. So its liabilities total US$10.5b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Baker Hughes has a huge market capitalization of US$29.2b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With net debt sitting at just 1.2 times EBITDA, Baker Hughes is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 7.4 times the interest expense over the last year. And we also note warmly that Baker Hughes grew its EBIT by 17% last year, making its debt load easier to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Baker Hughes’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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Baker Hughes recorded free cash flow worth 61% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Baker Hughes’s EBIT growth rate suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. And its conversion of EBIT to free cash flow is good too. Looking at all the aforementioned factors together, it strikes us that Baker Hughes can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it’s worth keeping an eye on this one. The balance sheet is clearly the area to focus on when you are analysing debt.