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, Howmet Aerospace Inc. (NYSE:HWM) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 Howmet Aerospace Carry?

The image below, which you can click on for greater detail, shows that Howmet Aerospace had debt of US$4.24b at the end of June 2021, a reduction from US$5.09b over a year. However, it also had US$715.0m in cash, and so its net debt is US$3.53b.

A Look At Howmet Aerospace’s Liabilities

Zooming in on the latest balance sheet data, we can see that Howmet Aerospace had liabilities of US$1.23b due within 12 months and liabilities of US$5.55b due beyond that. On the other hand, it had cash of US$715.0m and US$416.0m worth of receivables due within a year. So its liabilities total US$5.65b more than the combination of its cash and short-term receivables.

Howmet Aerospace has a very large market capitalization of US$13.6b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Howmet Aerospace’s debt to EBITDA ratio (3.3) suggests that it uses some debt, its interest cover is very weak, at 2.4, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Even worse, Howmet Aerospace saw its EBIT tank 32% over the last 12 months. If earnings keep going like that over the long term, it has a snowball’s chance in hell of paying off that debt. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Howmet Aerospace can strengthen its balance sheet over time.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Considering the last three years, Howmet Aerospace actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

On the face of it, Howmet Aerospace’s conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to handle its total liabilities isn’t such a worry. Overall, it seems to us that Howmet Aerospace’s balance sheet is really quite a risk to the business. So we’re almost as wary of this stock as a hungry kitten is about falling into its owner’s fish pond: once bitten, twice shy, as they say. The balance sheet is clearly the area to focus on when you are analysing debt.