Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Caltex Australia Limited (ASX:CTX) does have debt on its balance sheet. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is Caltex Australia's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Caltex Australia had AU$1.28b of debt, an increase on AU$1.08b, over one year. And it doesn't have much cash, so its net debt is about the same.
How Healthy Is Caltex Australia's Balance Sheet?
According to the last reported balance sheet, Caltex Australia had liabilities of AU$2.63b due within 12 months, and liabilities of AU$2.27b due beyond 12 months. Offsetting these obligations, it had cash of AU$17.7m as well as receivables valued at AU$1.18b due within 12 months. So its liabilities total AU$3.70b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Caltex Australia has a market capitalization of AU$6.32b, 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.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).
Caltex Australia has net debt worth 1.6 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 6.6 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. In fact Caltex Australia's saving grace is its low debt levels, because its EBIT has tanked 51% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Caltex Australia can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Caltex Australia recorded free cash flow of 45% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
We'd go so far as to say Caltex Australia's EBIT growth rate was disappointing. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Caltex Australia's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. Given our hesitation about the stock, it would be good to know if Caltex Australia insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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.
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