Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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 MDU Resources Group, Inc. (NYSE:MDU) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does MDU Resources Group Carry?
As you can see below, MDU Resources Group had US$2.38b 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$57.2m in cash leading to net debt of about US$2.32b.
How Strong Is MDU Resources Group’s Balance Sheet?
According to the last reported balance sheet, MDU Resources Group had liabilities of US$1.07b due within 12 months, and liabilities of US$4.16b due beyond 12 months. On the other hand, it had cash of US$57.2m and US$979.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$4.20b.
This is a mountain of leverage relative to its market capitalization of US$6.00b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
MDU Resources Group’s debt is 2.7 times its EBITDA, and its EBIT cover its interest expense 6.0 times over. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. MDU Resources Group grew its EBIT by 6.1% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. 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 MDU Resources Group’s ability to maintain a healthy balance sheet going forward.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we always check how much of that EBIT is translated into free cash flow. In the last three years, MDU Resources Group created free cash flow amounting to 4.9% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
MDU Resources Group’s conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability to to grow its EBIT isn’t too shabby at all. We should also note that Integrated Utilities industry companies like MDU Resources Group commonly do use debt without problems. When we consider all the factors discussed, it seems to us that MDU Resources Group 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.