Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘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. Importantly, Cleanaway Waste Management Limited (ASX:CWY) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.
View our latest analysis for Cleanaway Waste Management
What Is Cleanaway Waste Management’s Net Debt?
As you can see below, Cleanaway Waste Management had AU$993.4m of debt at December 2022, down from AU$1.07b a year prior. On the flip side, it has AU$124.9m in cash leading to net debt of about AU$868.5m.
How Healthy Is Cleanaway Waste Management’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Cleanaway Waste Management had liabilities of AU$843.9m due within 12 months and liabilities of AU$2.19b due beyond that. Offsetting these obligations, it had cash of AU$124.9m as well as receivables valued at AU$589.4m due within 12 months. So it has liabilities totalling AU$2.31b more than its cash and near-term receivables, combined.
This deficit isn’t so bad because Cleanaway Waste Management is worth AU$6.19b, 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.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
While Cleanaway Waste Management has a quite reasonable net debt to EBITDA multiple of 1.9, its interest cover seems weak, at 2.2. The main reason for this is that it has such high depreciation and amortisation. These charges may be non-cash, so they could be excluded when it comes to paying down debt. But the accounting charges are there for a reason — some assets are seen to be losing value. In any case, it’s safe to say the company has meaningful debt. Unfortunately, Cleanaway Waste Management’s EBIT flopped 19% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Cleanaway Waste Management’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 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Cleanaway Waste Management generated free cash flow amounting to a very robust 85% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.
Our View
Neither Cleanaway Waste Management’s ability to grow its EBIT nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. We think that Cleanaway Waste Management’s debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks…
Read More: Does Cleanaway Waste Management (ASX:CWY) Have A Healthy Balance Sheet?