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. Importantly, Baker Hughes Company (NYSE:BKR) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.

What Is Baker Hughes’s Debt?

As you can see below, at the end of March 2021, Baker Hughes had US$6.81b of debt, up from US$6.50b a year ago. Click the image for more detail. However, because it has a cash reserve of US$5.10b, its net debt is less, at about US$1.71b.

A Look At Baker Hughes’ Liabilities

According to the last reported balance sheet, Baker Hughes had liabilities of US$9.96b due within 12 months, and liabilities of US$9.45b due beyond 12 months. On the other hand, it had cash of US$5.10b and US$5.26b worth of receivables due within a year. So its liabilities total US$9.05b more than the combination of its cash and short-term receivables.

Baker Hughes has a very large market capitalization of US$21.1b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution.

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). 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).

While Baker Hughes’s low debt to EBITDA ratio of 0.74 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.9 times last year does give us pause. So we’d recommend keeping a close eye on the impact financing costs are having on the business. Shareholders should be aware that Baker Hughes’s EBIT was down 33% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. 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 58% 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.

Our View

Baker Hughes’s struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. In particular, its net debt to EBITDA was re-invigorating. When we consider all the factors discussed, it seems to us that Baker Hughes is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it.