The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘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, Corning Incorporated (NYSE:GLW) does carry debt. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 Corning Carry?
As you can see below, Corning had US$6.72b of debt, at December 2022, which is about the same as the year before. You can click the chart for greater detail. However, it does have US$1.67b in cash offsetting this, leading to net debt of about US$5.05b.
How Healthy Is Corning’s Balance Sheet?
We can see from the most recent balance sheet that Corning had liabilities of US$5.18b falling due within a year, and liabilities of US$12.0b due beyond that. Offsetting this, it had US$1.67b in cash and US$1.72b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$13.8b.
This deficit isn’t so bad because Corning is worth a massive US$28.9b, 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.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Corning has net debt worth 1.5 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 6.9 times the interest expense. While these numbers do not alarm us, it’s worth noting that the cost of the company’s debt is having a real impact. On the other hand, Corning’s EBIT dived 17%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. 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 Corning can strengthen its balance sheet over time.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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, Corning produced sturdy free cash flow equating to 65% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
Corning’s EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its conversion of EBIT to free cash flow is relatively strong. We think that Corning’s debt does make it a bit risky, after considering the aforementioned data points together. That’s not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. When analysing debt levels, the balance sheet is the obvious place to start.