David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the 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 note that Worthington Industries, Inc. (NYSE:WOR) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Worthington Industries’s Debt?
The chart below, which you can click on for greater detail, shows that Worthington Industries had US$706.4m in debt in August 2021; about the same as the year before. However, it does have US$399.2m in cash offsetting this, leading to net debt of about US$307.2m.
How Strong Is Worthington Industries’ Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Worthington Industries had liabilities of US$864.3m due within 12 months and liabilities of US$1.08b due beyond that. Offsetting these obligations, it had cash of US$399.2m as well as receivables valued at US$638.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$903.8m.
While this might seem like a lot, it is not so bad since Worthington Industries has a market capitalization of US$2.66b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Worthington Industries has a low net debt to EBITDA ratio of only 0.66. And its EBIT covers its interest expense a whopping 12.5 times over. So we’re pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that Worthington Industries grew its EBIT by 217% over twelve months. That boost will make it even easier to pay down debt going forward. 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 Worthington Industries’s ability to maintain a healthy balance sheet going forward.
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. Over the most recent three years, Worthington Industries recorded free cash flow worth 75% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Worthington Industries’s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. And the good news does not stop there, as its EBIT growth rate also supports that impression! Looking at the bigger picture, we think Worthington Industries’s use of debt seems quite reasonable and we’re not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. There’s no doubt that we learn most about debt from the balance sheet.