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.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies The Williams Companies, Inc. (NYSE:WMB) makes use of debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Williams Companies’s Net Debt?
As you can see below, Williams Companies had US$22.4b of debt, at September 2021, which is about the same as the year before. You can click the chart for greater detail. And it doesn’t have much cash, so its net debt is about the same.
How Healthy Is Williams Companies’ Balance Sheet?
According to the last reported balance sheet, Williams Companies had liabilities of US$4.94b due within 12 months, and liabilities of US$27.1b due beyond 12 months. Offsetting this, it had US$214.0m in cash and US$1.99b in receivables that were due within 12 months. So it has liabilities totalling US$29.9b more than its cash and near-term receivables, combined.
This deficit is considerable relative to its very significant market capitalization of US$36.8b, so it does suggest shareholders should keep an eye on Williams Companies’ use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Weak interest cover of 2.1 times and a disturbingly high net debt to EBITDA ratio of 5.2 hit our confidence in Williams Companies like a one-two punch to the gut. This means we’d consider it to have a heavy debt load. More concerning, Williams Companies saw its EBIT drop by 3.7% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its 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 Williams Companies 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. Over the last three years, Williams Companies recorded free cash flow worth a fulsome 83% of its EBIT, which is stronger than we’d usually expect. That positions it well to pay down debt if desirable to do so.
Neither Williams Companies’s ability handle its debt, based on its EBITDA, nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. Taking the abovementioned factors together we do think Williams Companies’s debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. When analysing debt levels, the balance sheet is the obvious place to start.