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 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, Koppers Holdings Inc. (NYSE:KOP) does carry debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Koppers Holdings Carry?
You can click the graphic below for the historical numbers, but it shows that Koppers Holdings had US$810.6m of debt in March 2021, down from US$953.2m, one year before. On the flip side, it has US$44.2m in cash leading to net debt of about US$766.4m.
How Strong Is Koppers Holdings’ Balance Sheet?
The latest balance sheet data shows that Koppers Holdings had liabilities of US$266.9m due within a year, and liabilities of US$1.00b falling due after that. On the other hand, it had cash of US$44.2m and US$194.7m worth of receivables due within a year. So it has liabilities totalling US$1.03b more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company’s market capitalization of US$736.4m, we think shareholders really should watch Koppers Holdings’s debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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).
Koppers Holdings’s debt is 3.2 times its EBITDA, and its EBIT cover its interest expense 4.2 times over. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. The good news is that Koppers Holdings grew its EBIT a smooth 56% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Koppers Holdings can strengthen its balance sheet over time.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Koppers Holdings recorded free cash flow of 31% of its EBIT, which is weaker than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
We’d go so far as to say Koppers Holdings’s level of total liabilities was disappointing. But at least it’s pretty decent at growing its EBIT; that’s encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Koppers Holdings stock a bit risky. Some people like that sort of risk, but we’re mindful of the potential pitfalls, so we’d probably prefer it carry less debt. 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.