David Iben said it well when he said: “Volatility is not a risk that interests us. What matters to us is to avoid the permanent loss of capital. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. Like many other companies Warner Music Group Corp. (NASDAQ:WMG) uses debt. But does this debt worry shareholders?

Why is debt risky?

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 usual (but still expensive) 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. The first step when considering a company’s debt levels is to consider its cash and debt together.

Check out our latest analysis for Warner Music Group

How much debt does Warner Music Group have?

You can click on the chart below for historical numbers, but it shows that as of December 2021, Warner Music Group had $3.86 billion in debt, an increase from $3.42 billion, on a year. However, since it has a cash reserve of $450.0 million, its net debt is less, at around $3.41 billion.

How strong is Warner Music Group’s balance sheet?

The latest balance sheet data shows that Warner Music Group had liabilities of $3.36 billion due within the year, and liabilities of $4.49 billion due thereafter. In return, it had $450.0 million in cash and $941.0 million in receivables to be received within 12 months. Thus, its liabilities outweigh the sum of its cash and (current) receivables by $6.45 billion.

While that might sound like a lot, it’s not too bad since Warner Music Group has a huge market capitalization of US$19.2 billion, so it could probably bolster its balance sheet by raising capital if needed. 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 ).

Warner Music Group’s debt is 3.5 times its EBITDA, and its EBIT covers its interest expense 5.4 times. This suggests that while debt levels are significant, we will refrain from labeling them as problematic. We also note that Warner Music Group improved its EBIT from last year’s loss to a positive result of $652 million. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future earnings, more than anything, that will determine Warner Music Group’s ability to maintain a healthy balance sheet in the future. 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 cold hard cash, not with book profits. It is therefore worth checking how much of earnings before interest and tax (EBIT) is supported by free cash flow. In the most recent year, Warner Music Group reported free cash flow of 26% of EBIT, which is weaker than expected. It’s not great when it comes to paying off debt.

Our point of view

Warner Music Group’s net debt to EBITDA and its conversion of EBIT to free cash flow were disheartening. But it’s not so bad to cover its interest expense with its EBIT. Considering the above factors, we believe that Warner Music Group’s debt poses certain risks to the business. So even if this leverage increases return on equity, we wouldn’t really want to see it increase from now on. 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. To do this, you need to find out about the 3 warning signs we spotted some with Warner Music Group (including 1 which is a bit unpleasant).

In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.

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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.