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.’ 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. Importantly, BorgWarner Inc. (NYSE:BWA) does carry debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is BorgWarner’s Net Debt?
The image below, which you can click on for greater detail, shows that at September 2021 BorgWarner had debt of US$4.34b, up from US$2.84b in one year. However, because it has a cash reserve of US$1.51b, its net debt is less, at about US$2.84b.
How Strong Is BorgWarner’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that BorgWarner had liabilities of US$3.64b due within 12 months and liabilities of US$5.83b due beyond that. Offsetting these obligations, it had cash of US$1.51b as well as receivables valued at US$2.91b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$5.05b.
While this might seem like a lot, it is not so bad since BorgWarner has a huge market capitalization of US$10.3b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
BorgWarner’s net debt is only 1.2 times its EBITDA. And its EBIT covers its interest expense a whopping 17.1 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In addition to that, we’re happy to report that BorgWarner has boosted its EBIT by 82%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if BorgWarner 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, BorgWarner produced sturdy free cash flow equating to 52% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Our View
BorgWarner’s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. But truth be told we feel its level of total liabilities does undermine this impression a bit. Taking all this data into account, it seems to us that BorgWarner takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. The balance sheet is clearly the area to focus on when you are analysing debt.