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.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Delta Air Lines, Inc. (NYSE:DAL) does use debt in its business. But the more important question is: how much risk is that debt creating?
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. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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 Delta Air Lines Carry?
The image below, which you can click on for greater detail, shows that Delta Air Lines had debt of US$21.4b at the end of March 2023, a reduction from US$24.9b over a year. On the flip side, it has US$6.61b in cash leading to net debt of about US$14.8b.
How Strong Is Delta Air Lines’ Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Delta Air Lines had liabilities of US$28.4b due within 12 months and liabilities of US$38.5b due beyond that. On the other hand, it had cash of US$6.61b and US$3.22b worth of receivables due within a year. So it has liabilities totalling US$57.0b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the US$22.3b company, like a colossus towering over mere mortals. So we’d watch its balance sheet closely, without a doubt. At the end of the day, Delta Air Lines would probably need a major re-capitalization if its creditors were to demand repayment.
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).
Delta Air Lines has net debt worth 2.1 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 5.1 times the interest expense. While that doesn’t worry us too much, it does suggest the interest payments are somewhat of a burden. Notably, Delta Air Lines made a loss at the EBIT level, last year, but improved that to positive EBIT of US$5.1b in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Delta Air Lines’s ability to maintain a healthy balance sheet going forward.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it’s worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Looking at the most recent year, Delta Air Lines recorded free cash flow of 24% of its EBIT, which is weaker than we’d expect. That’s not great, when it comes to paying down debt.
Our View
We’d go so far as to say Delta Air Lines’s level of total liabilities was disappointing. But at least its interest cover is not so bad. Overall, it seems to us that Delta Air Lines’s balance sheet is really quite a risk to the business. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. There’s no doubt that we learn most about debt from the balance sheet.