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. 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 can see that Olympic Steel, Inc. (NASDAQ:ZEUS) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Olympic Steel’s Net Debt?
As you can see below, at the end of September 2019, Olympic Steel had US$226.8m of debt, up from US$304 a year ago. Click the image for more detail. However, it does have US$8.49m in cash offsetting this, leading to net debt of about US$218.3m.
A Look At Olympic Steel’s Liabilities
Zooming in on the latest balance sheet data, we can see that Olympic Steel had liabilities of US$117.6m due within 12 months and liabilities of US$272.5m due beyond that. Offsetting these obligations, it had cash of US$8.49m as well as receivables valued at US$168.0m due within 12 months. So it has liabilities totalling US$213.6m more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company’s US$174.7m market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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).
Weak interest cover of 1.4 times and a disturbingly high net debt to EBITDA ratio of 6.8 hit our confidence in Olympic Steel like a one-two punch to the gut. The debt burden here is substantial. Even worse, Olympic Steel saw its EBIT tank 67% 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. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Olympic Steel’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Olympic Steel recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.
Our View
To be frank both Olympic Steel’s net debt to EBITDA and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And furthermore, its conversion of EBIT to free cash flow also fails to instill confidence. Considering all the factors previously mentioned, we think that Olympic Steel really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. For example, we’ve discovered 2 warning signs for Olympic Steel (1 is potentially serious!) that you should be aware of before investing here.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
