We believe West Fraser Timber (TSE: WFG) can keep up with its debt
Legendary fund manager Li Lu (whom Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. So it might be obvious, then, that you need to factor in debt, when you think about how risky a given stock is because too much debt can sink a business. We can see that West Fraser Timber Co. Ltd. (TSE: WFG) uses debt in its business. But the real question is whether this debt makes the business risky.
When is debt dangerous?
Debt helps a business until it struggles to pay it off, either with new capital or with free cash flow. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. While it’s not too common, we often see indebted companies continually diluting shareholders because lenders are forcing them to raise capital at a difficult price. 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. The first thing to do when considering how much debt a business uses is to look at its cash flow and debt together.
Check out our latest review for West Fraser lumber
What is West Fraser Timber’s debt?
The image below, which you can click for more details, shows that in March 2021, West Fraser Timber was in debt of US $ 1.21 billion, up from US $ 989.1 million in a year. . But on the other hand, it also has US $ 1.40 billion in cash, which leads to a net cash position of US $ 187.4 million.
A look at the responsibilities of West Fraser Timber
Zooming in on the latest balance sheet data, we can see that West Fraser Timber had liabilities of US $ 1.45 billion due within 12 months and liabilities of US $ 1.91 billion beyond. In contrast, it had US $ 1.40 billion in cash and US $ 679.0 million in receivables due within one year. Its liabilities therefore total $ 1.28 billion more than the combination of its cash and short-term receivables.
Given that West Fraser Timber’s publicly traded shares are worth a total of US $ 9.13 billion, it seems unlikely that this level of liabilities poses a major threat. But there are enough liabilities that we would certainly recommend that shareholders continue to monitor the balance sheet going forward. While she has some liabilities to note, West Fraser Timber also has more cash than debt, so we’re pretty confident that she can handle her debt safely.
It was also good to see that despite losing money on the EBIT line last year, West Fraser Timber has been a game changer over the past 12 months, with EBIT of US $ 1.8 billion. . The balance sheet is clearly the area to focus on when analyzing debt. But it is future earnings, more than anything, that will determine West Fraser Timber’s ability to maintain a healthy balance sheet going forward. So if you are focused on the future you can check out this free report showing analysts’ earnings forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits do not reduce it. While West Fraser Timber has net cash on its balance sheet, it’s still worth looking at its ability to convert earnings before interest and taxes (EBIT) into free cash flow, to help us understand how fast it’s building. (or erode) that cash balance. Over the past year, West Fraser Timber has produced strong free cash flow equivalent to 79% of its EBIT, roughly what we expected. This free cash flow puts the business in a good position to repay debt, if any.
While West Fraser Timber’s balance sheet is not particularly strong, due to total liabilities, it is clearly positive that it has net cash of US $ 187.4 million. And it impressed us with free cash flow of US $ 1.4 billion, or 79% of its EBIT. So, is West Fraser Timber debt a risk? It does not seem to us. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist off the balance sheet. For example, we have identified 2 warning signs for West Fraser Timber that you need to be aware of.
At the end of the day, it’s often best to focus on businesses with no net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.
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