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, Westlake Chemical Corporation (NYSE:WLK) does carry debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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.
How Much Debt Does Westlake Chemical Carry?
As you can see below, Westlake Chemical had US$2.70b of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, because it has a cash reserve of US$409.0m, its net debt is less, at about US$2.29b.
How Strong Is Westlake Chemical's Balance Sheet?
We can see from the most recent balance sheet that Westlake Chemical had liabilities of US$1.25b falling due within a year, and liabilities of US$4.70b due beyond that. Offsetting this, it had US$409.0m in cash and US$1.21b in receivables that were due within 12 months. So its liabilities total US$4.34b more than the combination of its cash and short-term receivables.
This deficit isn't so bad because Westlake Chemical is worth US$7.94b, and thus could probably raise enough capital to shore up 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
With net debt sitting at just 1.4 times EBITDA, Westlake Chemical is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 9.8 times the interest expense over the last year. Importantly, Westlake Chemical's EBIT fell a jaw-dropping 37% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 Westlake Chemical's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Westlake Chemical recorded free cash flow worth 55% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Westlake Chemical's EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. In particular, its interest cover was re-invigorating. Taking the abovementioned factors together we do think Westlake Chemical's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. Over time, share prices tend to follow earnings per share, so if you're interested in Westlake Chemical, you may well want to click here to check an interactive graph of its earnings per share history.
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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