Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Altria Group, Inc. (NYSE:MO) makes use of debt. But the more important question is: how much risk is that debt creating?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.

What Is Altria Group’s Net Debt?

As you can see below, Altria Group had US$29.7b of debt, at March 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$5.79b in cash leading to net debt of about US$23.9b.

How Healthy Is Altria Group’s Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Altria Group had liabilities of US$10.0b due within 12 months and liabilities of US$35.7b due beyond that. On the other hand, it had cash of US$5.79b and US$142.0m worth of receivables due within a year. So its liabilities total US$39.8b more than the combination of its cash and short-term receivables.

This deficit isn’t so bad because Altria Group is worth a massive US$93.1b, and thus could probably raise enough capital to shore up 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.

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). 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).

With a debt to EBITDA ratio of 2.0, Altria Group uses debt artfully but responsibly. And the alluring interest cover (EBIT of 9.1 times interest expense) certainly does not do anything to dispel this impression. We saw Altria Group grow its EBIT by 3.1% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Altria Group can strengthen its balance sheet over time.

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. Over the most recent three years, Altria Group recorded free cash flow worth 74% 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

The good news is that Altria Group’s demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its interest cover also supports that impression! Looking at all the aforementioned factors together, it strikes us that Altria Group can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it’s worth monitoring the balance sheet. 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.