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 MRC Global Inc. (NYSE:MRC) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company’s use of debt, we first look at cash and debt together.
What Is MRC Global’s Debt?
The image below, which you can click on for greater detail, shows that MRC Global had debt of US$303.0m at the end of September 2023, a reduction from US$341.0m over a year. However, because it has a cash reserve of US$52.0m, its net debt is less, at about US$251.0m.
A Look At MRC Global’s Liabilities
We can see from the most recent balance sheet that MRC Global had liabilities of US$590.0m falling due within a year, and liabilities of US$550.0m due beyond that. Offsetting these obligations, it had cash of US$52.0m as well as receivables valued at US$518.0m due within 12 months. So it has liabilities totalling US$570.0m more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of US$870.0m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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.
Looking at its net debt to EBITDA of 1.1 and interest cover of 5.9 times, it seems to us that MRC Global is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. It is well worth noting that MRC Global’s EBIT shot up like bamboo after rain, gaining 83% in the last twelve months. That’ll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if MRC Global can strengthen its balance sheet over time.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, MRC Global produced sturdy free cash flow equating to 58% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Our View
The good news is that MRC Global’s demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its level of total liabilities. All these things considered, it appears that MRC Global 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.