Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. We note that WEX Inc. (NYSE:WEX) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. 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 WEX Carry?
You can click the graphic below for the historical numbers, but it shows that WEX had US$2.87b of debt in December 2021, down from US$3.07b, one year before. On the flip side, it has US$1.54b in cash leading to net debt of about US$1.33b.
How Strong Is WEX’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that WEX had liabilities of US$4.40b due within 12 months and liabilities of US$3.81b due beyond that. Offsetting these obligations, it had cash of US$1.54b as well as receivables valued at US$3.03b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$3.65b.
While this might seem like a lot, it is not so bad since WEX has a market capitalization of US$7.26b, 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
WEX’s net debt is sitting at a very reasonable 2.4 times its EBITDA, while its EBIT covered its interest expense just 4.0 times last year. While these numbers do not alarm us, it’s worth noting that the cost of the company’s debt is having a real impact. Pleasingly, WEX is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 105% gain in the last twelve months. 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 WEX can strengthen its balance sheet over time.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, WEX actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Our View
The good news is that WEX’s demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its interest cover. All these things considered, it appears that WEX can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it’s worth keeping an eye on this one. The balance sheet is clearly the area to focus on when you are analysing debt.