Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. We notice that Ashland Global Holdings Inc. (NYSE:ASH) has debt on its balance sheet. But the more important question is: what risk does this debt create?

Why is debt risky?

Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. However, a more frequent (but still costly) event is when a company has to issue shares at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.

Check out our latest analysis for Ashland Global Holdings

How much debt does Ashland Global Holdings have?

You can click on the graph below for historical numbers, but it shows that in December 2021, Ashland Global Holdings had $1.97 billion in debt, an increase from $1.69 billion, on a year. However, since it has a cash reserve of $194.0 million, its net debt is less, at around $1.78 billion.

How strong is Ashland Global Holdings’ balance sheet?

We can see from the most recent balance sheet that Ashland Global Holdings had liabilities of US$908.0 million due within a year, and liabilities of US$2.88 billion due of the. In compensation for these obligations, it had cash of US$194.0 million as well as receivables valued at US$340.0 million and maturing within 12 months. Thus, its liabilities outweigh the sum of its cash and (current) receivables by $3.25 billion.

Ashland Global Holdings has a market capitalization of US$5.53 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 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.

Ashland Global Holdings’ debt is 3.8 times its EBITDA, and its EBIT covers its interest expense 2.8 times. This suggests that while debt levels are significant, we will refrain from labeling them as problematic. Even more troubling is the fact that Ashland Global Holdings actually let its EBIT decline by 3.9% over the past year. If he continues like this, paying off his debt will be like running on a treadmill – a lot of effort for little progress. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future earnings, more than anything, that will determine Ashland Global Holdings’ ability to maintain a healthy balance sheet in the future. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.

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, Ashland Global Holdings has actually produced more free cash flow than EBIT. This kind of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our point of view

Neither Ashland Global Holdings’ ability to cover its interest expense with its EBIT nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story and suggests some resilience. Looking at all the angles discussed above, it does seem to us that Ashland Global Holdings is a somewhat risky investment due to its leverage. Not all risk is bad, as it can increase stock price returns if it pays off, but this leverage risk is worth keeping in mind. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist outside of the balance sheet. Example: we have identified 1 warning sign for Ashland Global Holdings you should be aware.

In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeat present.

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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.