Is Steel Dynamics (NASDAQ:STLD) 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”. 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. Like many other companies Steel Dynamics, Inc. (NASDAQ:STLD) uses debt. 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, many companies use debt to finance their growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.
Check out our latest analysis for Steel Dynamics
What is Steel Dynamics’ net debt?
The graph below, which you can click on for more details, shows that Steel Dynamics had $3.08 billion in debt as of March 2022; about the same as the previous year. However, since he has a cash reserve of $1.19 billion, his net debt is less, at around $1.89 billion.
How strong is Steel Dynamics’ balance sheet?
We can see from the most recent balance sheet that Steel Dynamics had liabilities of $2.09 billion due in one year, and liabilities of $3.99 billion beyond that. In return, he had $1.19 billion in cash and $2.36 billion in receivables due within 12 months. It therefore has liabilities totaling $2.53 billion more than its cash and short-term receivables, combined.
Given that publicly traded Steel Dynamics shares are worth a very impressive total of US$16.6 billion, it seems unlikely that this level of liability is a major threat. However, we think it’s worth keeping an eye on the strength of its balance sheet, as it can change over time.
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 ).
Steel Dynamics has a low net debt to EBITDA ratio of just 0.34. And its EBIT easily covers its interest costs, which is 91.9 times the size. One could therefore say that he is no more threatened by his debt than an elephant is by a mouse. What’s even more impressive is that Steel Dynamics increased its EBIT by 338% year-over-year. If sustained, this growth will make debt even more manageable in years to come. There is no doubt that we learn the most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Steel Dynamics’ 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. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Over the past three years, Steel Dynamics has recorded free cash flow of 33% of its EBIT, which is lower than expected. This low cash conversion makes debt management more difficult.
Our point of view
The good news is that Steel Dynamics’ demonstrated ability to cover its interest costs with its EBIT delights us like a fluffy puppy does a toddler. But truth be told, we think his conversion of EBIT to free cash flow somewhat undermines that impression. Zooming out, Steel Dynamics seems to be using debt quite sensibly; and that gets the green light from us. After all, reasonable leverage can increase return on equity. The balance sheet is clearly the area to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist outside of the balance sheet. Be aware that Steel Dynamics displays 4 warning signs in our investment analysis and 2 of them are significant…
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.