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. As with many other companies Koppers Holdings Inc. (NYSE:KOP) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Koppers Holdings Carry?
You can click the graphic below for the historical numbers, but it shows that Koppers Holdings had US$806.2m of debt in June 2021, down from US$907.1m, one year before. However, it does have US$44.2m in cash offsetting this, leading to net debt of about US$762.0m.
How Healthy Is Koppers Holdings’ Balance Sheet?
The latest balance sheet data shows that Koppers Holdings had liabilities of US$265.2m due within a year, and liabilities of US$992.7m falling due after that. On the other hand, it had cash of US$44.2m and US$205.5m worth of receivables due within a year. So it has liabilities totalling US$1.01b more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company’s US$713.8m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). 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).
Koppers Holdings has a debt to EBITDA ratio of 3.2 and its EBIT covered its interest expense 4.2 times. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. The good news is that Koppers Holdings grew its EBIT a smooth 36% over the last twelve months. Like a mother’s loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Koppers Holdings’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Koppers Holdings recorded free cash flow of 31% of its EBIT, which is weaker than we’d expect. That’s not great, when it comes to paying down debt.
Mulling over Koppers Holdings’s attempt at staying on top of its total liabilities, we’re certainly not enthusiastic. But at least it’s pretty decent at growing its EBIT; that’s encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Koppers Holdings stock a bit risky. That’s not necessarily a bad thing, but we’d generally feel more comfortable with less leverage. When analysing debt levels, the balance sheet is the obvious place to start.