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.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Corning Incorporated (NYSE:GLW) makes use of debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Corning’s Net Debt?
As you can see below, Corning had US$7.80b of debt, at March 2021, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has US$2.87b in cash leading to net debt of about US$4.94b.
A Look At Corning’s Liabilities
The latest balance sheet data shows that Corning had liabilities of US$3.51b due within a year, and liabilities of US$13.1b falling due after that. Offsetting this, it had US$2.87b in cash and US$1.90b in receivables that were due within 12 months. So its liabilities total US$11.8b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Corning has a huge market capitalization of US$34.7b, 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.
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). 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).
Corning has net debt worth 1.5 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 6.4 times the interest expense. While these numbers do not alarm us, it’s worth noting that the cost of the company’s debt is having a real impact. In addition to that, we’re happy to report that Corning has boosted its EBIT by 31%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Corning can strengthen its balance sheet over time.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Corning’s free cash flow amounted to 45% of its EBIT, less than we’d expect. That’s not great, when it comes to paying down debt.
Our View
The good news is that Corning’s demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. And its net debt to EBITDA is good too. Looking at all the aforementioned factors together, it strikes us that Corning can handle its debt fairly comfortably. 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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet.