Some say volatility, rather than debt, is the best way to view risk as an investor, but Warren Buffett said “volatility is far from risk.” So it seems like smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess the level of risk of a business. Like many other companies Westlake Chemical Corporation (NYSE: WLK) uses debt. But should shareholders be concerned about its use of debt?
When is debt dangerous?
Generally speaking, debt only becomes a real problem when a company cannot repay it easily, either by raising capital or with its own cash flow. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. However, a more common (but still painful) scenario is that he must raise new equity at low cost, thereby diluting shareholders over the long term. Of course, many companies use debt to finance their growth without negative consequences. When we look at debt levels, we first look at cash and debt levels together.
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What is Westlake Chemical’s net debt?
You can click on the graph below for the historical figures, but it shows that Westlake Chemical was in debt of US $ 3.55 billion in March 2021, down from US $ 4.43 billion a year earlier. However, given that it has a cash reserve of US $ 1.39 billion, its net debt is less, at around US $ 2.15 billion.
How strong is Westlake Chemical’s balance sheet?
We can see from the most recent balance sheet that Westlake Chemical had liabilities of US $ 1.33 billion maturing within one year and liabilities of US $ 5.90 billion maturing beyond that. . In return, he had $ 1.39 billion in cash and $ 1.33 billion in receivables due within 12 months. It therefore has liabilities totaling US $ 4.51 billion more than its cash and short-term receivables combined.
Westlake Chemical has a very large market capitalization of US $ 10.5 billion, so it could most likely raise funds to improve its balance sheet, should the need arise. However, it is always worth taking a close look at your ability to repay your debt.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt versus EBITDA) and the actual interest charges associated with this debt (with its coverage rate). interests).
Westlake Chemical has net debt worth 1.5 times EBITDA, which isn’t too much, but its interest coverage looks a bit low, with EBIT just 5.3 times interest expense. It appears the company incurs significant depreciation and amortization costs, so perhaps its debt load is heavier than it first appears, since EBITDA is arguably a generous measure of profits. Westlake Chemical increased its EBIT by 2.4% last year. While this hardly strikes us, it is a bright spot when it comes to debt. The balance sheet is clearly the area you need to focus on when analyzing debt. But it is future profits, more than anything, that will determine Westlake Chemical’s ability to maintain a healthy balance sheet going forward. So, if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, a business can only repay its debts with hard cash, not with book profits. We must therefore clearly check whether this EBIT generates a corresponding free cash flow. Over the past three years, Westlake Chemical has generated strong free cash flow equivalent to 80% of its EBIT, roughly what we expected. This free cash flow puts the business in a good position to repay debt, if any.
Our point of view
The good news is that Westlake Chemical’s demonstrated ability to convert EBIT into free cash flow delights us like a fluffy puppy does a toddler. And its net debt to EBITDA is good too. Looking at all of the above factors together, it seems to us that Westlake Chemical can manage its debt quite comfortably. Of course, while this leverage can improve returns on equity, it brings more risk, so it’s worth keeping an eye out for. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks lie on the balance sheet – far from it. For example, we discovered 4 warning signs for Westlake Chemical (1 makes us a little uncomfortable!) Which you should be aware of before investing here.
At the end of the day, it’s often best to focus on businesses with no net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.
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