The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Cleveland-Cliffs Inc. (NYSE:CLF) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Cleveland-Cliffs's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2021 Cleveland-Cliffs had US$5.37b of debt, an increase on US$4.45b, over one year. Net debt is about the same, since the it doesn't have much cash.
How Healthy Is Cleveland-Cliffs' Balance Sheet?
According to the last reported balance sheet, Cleveland-Cliffs had liabilities of US$2.99b due within 12 months, and liabilities of US$10.5b due beyond 12 months. Offsetting these obligations, it had cash of US$73.0m as well as receivables valued at US$2.06b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$11.3b.
This deficit is considerable relative to its very significant market capitalization of US$12.1b, so it does suggest shareholders should keep an eye on Cleveland-Cliffs' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Cleveland-Cliffs's net debt is sitting at a very reasonable 2.2 times its EBITDA, while its EBIT covered its interest expense just 5.7 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Pleasingly, Cleveland-Cliffs is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 42,781% gain in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Cleveland-Cliffs 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Cleveland-Cliffs burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
Our View
Cleveland-Cliffs's conversion of EBIT to free cash flow and level of total liabilities definitely weigh on it, in our esteem. But the good news is it seems to be able to grow its EBIT with ease. Taking the abovementioned factors together we do think Cleveland-Cliffs's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 5 warning signs for Cleveland-Cliffs (of which 2 are a bit concerning!) you should know about.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an 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 account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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