David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Clearwater Paper Corporation (NYSE:CLW) makes use of debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Clearwater Paper Carry?
As you can see below, Clearwater Paper had US$676.5m of debt at September 2021, down from US$766.0m a year prior. However, it does have US$27.8m in cash offsetting this, leading to net debt of about US$648.7m.
How Healthy Is Clearwater Paper’s Balance Sheet?
According to the last reported balance sheet, Clearwater Paper had liabilities of US$256.9m due within 12 months, and liabilities of US$969.6m due beyond 12 months. Offsetting this, it had US$27.8m in cash and US$159.4m in receivables that were due within 12 months. So its liabilities total US$1.04b more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the US$687.1m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we’d watch its balance sheet closely, without a doubt. After all, Clearwater Paper would likely require a major re-capitalisation if it had to pay its creditors today.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While we wouldn’t worry about Clearwater Paper’s net debt to EBITDA ratio of 3.6, we think its super-low interest cover of 1.9 times is a sign of high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Worse, Clearwater Paper’s EBIT was down 46% over the last year. If earnings keep going like that over the long term, it has a snowball’s chance in hell of paying off that debt. 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 Clearwater Paper’s ability to maintain a healthy balance sheet going forward.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Clearwater Paper’s free cash flow amounted to 35% of its EBIT, less than we’d expect. That’s not great, when it comes to paying down debt.
Our View
To be frank both Clearwater Paper’s level of total liabilities and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least its conversion of EBIT to free cash flow is not so bad. Taking into account all the aforementioned factors, it looks like Clearwater Paper has too much debt. That sort of riskiness is ok for some, but it certainly doesn’t float our boat. When analysing debt levels, the balance sheet is the obvious place to start.