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.’ 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 Eastman Chemical Company (NYSE:EMN) makes use of 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 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, 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Eastman Chemical Carry?
As you can see below, Eastman Chemical had US$5.55b of debt at March 2021, down from US$6.30b a year prior. However, it also had US$540.0m in cash, and so its net debt is US$5.01b.
How Healthy Is Eastman Chemical’s Balance Sheet?
According to the last reported balance sheet, Eastman Chemical had liabilities of US$2.02b due within 12 months, and liabilities of US$7.86b due beyond 12 months. On the other hand, it had cash of US$540.0m and US$1.67b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$7.67b.
While this might seem like a lot, it is not so bad since Eastman Chemical has a huge market capitalization of US$15.9b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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). 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).
Eastman Chemical has a debt to EBITDA ratio of 3.2 and its EBIT covered its interest expense 4.8 times. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. Importantly, Eastman Chemical’s EBIT fell a jaw-dropping 23% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Eastman Chemical 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. During the last three years, Eastman Chemical generated free cash flow amounting to a very robust 93% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.
Eastman Chemical’s EBIT growth rate and net debt to EBITDA definitely weigh on it, in our esteem. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. We think that Eastman Chemical’s debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start.