Is Worley (ASX:WOR) using too much debt?

Howard Marks said it well when he said that, rather than worrying about stock price volatility, “the possibility of permanent loss is the risk I worry about…and that every practical investor that I know is worried”. 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 Worley Limited (ASX:WOR) uses debt in its business. But should shareholders worry about its use of debt?

What risk does debt carry?

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. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. However, a more common (but still costly) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. When we think about a company’s use of debt, we first look at cash and debt together.

See our latest analysis for Worley

What is Worley’s debt?

As you can see below, at the end of December 2021, Worley had A$1.95 billion in debt, up from A$1.71 billion a year ago. Click on the image for more details. However, he also had A$562.0 million in cash, so his net debt is A$1.38 billion.

ASX: Debt to Equity History June 28, 2022

How healthy is Worley’s balance sheet?

The latest balance sheet data shows Worley had liabilities of A$2.48 billion due within a year, and A$1.98 billion in liabilities falling due thereafter. On the other hand, it had cash of A$562.0 million and A$1.91 billion of receivables due within one year. It therefore has liabilities totaling A$1.99 billion more than its cash and short-term receivables, combined.

Worley has a market capitalization of A$7.37 billion, so it could very likely raise funds to improve its balance sheet, should the need arise. But we definitely want to keep our eyes peeled for indications that its debt is too risky.

We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).

Worley’s debt is 2.5 times its EBITDA, and its EBIT covers its interest expense 6.7 times. This suggests that while debt levels are significant, we will refrain from labeling them as problematic. The bad news is that Worley has seen its EBIT drop 12% over the past year. If that kind of decline isn’t stopped, then managing his debt will be harder than selling broccoli-flavored ice cream for a bounty. 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 Worley 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, a company can only repay its debts with cash, not book profits. We therefore always check how much of this EBIT is converted into free cash flow. Fortunately for all shareholders, Worley has actually produced more free cash flow than EBIT over the past three years. This kind of high cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our point of view

When it comes to the balance sheet, the most notable positive for Worley is the fact that he seems able to convert EBIT to free cash flow with confidence. But the other factors we noted above weren’t so encouraging. In particular, the EBIT growth rate gives us chills. Looking at all this data, we feel a little cautious about Worley’s debt levels. While debt has its upside in higher potential returns, we think shareholders should certainly consider how debt levels might make the stock more risky. 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. For example, we have identified 2 warning signs for Worley of which you should be aware.

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.

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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