Legendary fund manager Li Lu (whom Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but the possibility that you will suffer a permanent loss of capital.” It is only natural to consider a company’s balance sheet when considering how risky it is, as debt is often involved when a business collapses. We note that Cleveland-Cliffs Inc. (NYSE: CLF) has debt on its balance sheet. But should shareholders be concerned about its use of debt?
When is Debt a Problem?
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. If things really go wrong, lenders can take over the business. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. That said, the most common situation is where a business manages its debt reasonably well – and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash flow and debt together.
See our latest review for Cleveland-Cliffs
What is Cleveland-Cliffs net debt?
As you can see below, at the end of September 2021, Cleveland-Cliffs was in debt of $ 5.35 billion, down from $ 4.31 billion a year ago. Click on the image for more details. Net debt is about the same because it doesn’t have a lot of cash.
A look at the responsibilities of Cleveland-Cliffs
We can see from the most recent balance sheet that Cleveland-Cliffs had liabilities of US $ 3.28 billion maturing within one year and liabilities of US $ 10.5 billion maturing within one year. of the. In return, he had $ 42.0 million in cash and $ 2.35 billion in receivables due within 12 months. As a result, it has liabilities totaling US $ 11.4 billion more than its cash and short-term receivables combined.
When you consider that this deficiency exceeds the company’s massive US $ 10.2 billion market cap, you may well be inclined to take a close look at the balance sheet. In theory, extremely large dilution would be required if the company were forced to repay debts by raising capital at the current share price.
In order to measure a company’s debt relative to its profits, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its profit before interest and taxes (EBIT) divided by its interest. debtors (its interest coverage). 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).
Cleveland-Cliffs net debt is only 1.3 times its EBITDA. And its EBIT easily covers its interest costs, being 10.5 times greater. So we’re pretty relaxed about its ultra-conservative use of debt. It was also good to see that despite losing money on the EBIT line last year, Cleveland-Cliffs has been a game-changer over the past 12 months, delivering EBIT of US $ 3.4 billion. . There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether Cleveland-Cliffs can strengthen its balance sheet over time. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
Finally, a business needs free cash flow to pay off debts; accounting profits are not enough. It is therefore worth checking to what extent profit before interest and taxes (EBIT) is supported by free cash flow. As of the most recent year, Cleveland-Cliffs recorded free cash flow of 24% of its EBIT, which is lower than expected. It’s not great when it comes to paying down debt.
Our point of view
We would go so far as to say that Cleveland-Cliffs’ total liability level was disappointing. But at least it’s decent enough to cover its interest costs with its EBIT; it’s encouraging. Looking at the balance sheet and taking all of these factors into account, we think debt makes Cleveland-Cliffs stock a bit risky. Some people like this kind of risk, but we are aware of the potential pitfalls, so we would probably prefer him to carry less debt. 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, Cleveland-Cliffs has 4 warning signs (and 1 which is a little worrying) we think you should be aware of.
If you want to invest in companies that can generate profits without the burden of debt, check out this free list of growing companies that have net cash on the balance sheet.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.