Warren Buffett famously said, ‘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. Importantly, BorgWarner Inc. (NYSE:BWA) does carry debt. But should shareholders be worried about its use of debt?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 BorgWarner’s Net Debt?
The image below, which you can click on for greater detail, shows that BorgWarner had debt of US$4.14b at the end of September 2022, a reduction from US$4.34b over a year. However, because it has a cash reserve of US$1.24b, its net debt is less, at about US$2.90b.
How Healthy Is BorgWarner’s Balance Sheet?
The latest balance sheet data shows that BorgWarner had liabilities of US$3.82b due within a year, and liabilities of US$5.22b falling due after that. Offsetting this, it had US$1.24b in cash and US$3.38b in receivables that were due within 12 months. So it has liabilities totalling US$4.42b more than its cash and near-term receivables, combined.
BorgWarner has a very large market capitalization of US$10.2b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. 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.
BorgWarner has a low net debt to EBITDA ratio of only 1.4. And its EBIT covers its interest expense a whopping 34.3 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the bad news is that BorgWarner has seen its EBIT plunge 15% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine BorgWarner’s ability to maintain a healthy balance sheet going forward.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, BorgWarner recorded free cash flow of 41% of its EBIT, which is weaker than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
Our View
BorgWarner’s EBIT growth rate and level of total liabilities definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. We think that BorgWarner’s debt does make it a bit risky, after considering the aforementioned data points together. That’s not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt.