Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. We can see that Eastman Chemical Company (NYSE:EMN) uses debt in its operations. But should shareholders worry about its use of debt?
When is debt a problem?
Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. The first step when considering a company’s debt levels is to consider its cash and debt together.
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What is Eastman Chemical’s debt?
As you can see below, Eastman Chemical had US$4.99 billion in debt as of June 2022, up from US$5.57 billion the previous year. On the other hand, it has $470.0 million in cash, resulting in a net debt of around $4.52 billion.
How healthy is Eastman Chemical’s balance sheet?
We can see from the most recent balance sheet that Eastman Chemical had liabilities of US$3.15 billion due in one year, and liabilities of US$6.32 billion due beyond. On the other hand, it had cash of $470.0 million and $1.64 billion in receivables within one year. It therefore has liabilities totaling $7.36 billion more than its cash and short-term receivables, combined.
This shortfall is sizable relative to its very large market capitalization of US$10.1 billion, so it suggests shareholders watch Eastman Chemical’s use of debt. If its lenders asked it to shore up its balance sheet, shareholders would likely face significant dilution.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Eastman Chemical’s net debt of 2.0x EBITDA suggests judicious use of debt. And the fact that its trailing twelve months EBIT was 9.5 times its interest expense aligns with that theme. Importantly, Eastman Chemical has grown its EBIT by 43% over the last twelve months, and this growth will make it easier to manage its debt. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, the company’s future profitability will decide whether Eastman Chemical can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, while the taxman may love accounting profits, lenders only accept cash. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Eastman Chemical has produced strong free cash flow equivalent to 72% of its EBIT, which is what we expected. This free cash flow puts the company in a good position to repay its debt, should it arise.
Our point of view
The good news is that Eastman Chemical’s demonstrated ability to increase EBIT thrills us like a fluffy puppy does a toddler. But truth be told, we think his total passive level undermines that impression a bit. Looking at all of the aforementioned factors together, it seems to us that Eastman Chemical can manage its debt quite comfortably. Of course, while this leverage can improve return on equity, it comes with 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 reside on the balance sheet, far from it. We have identified 1 warning sign with Eastman Chemical, and understanding them should be part of your investment process.
If you are interested in investing in companies that can generate profits without the burden of debt, then 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 only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.
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