Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that United Rentals, Inc. (NYSE:URI) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.
View our latest analysis for United Rentals
What Is United Rentals’s Net Debt?
As you can see below, United Rentals had US$9.55b of debt at December 2020, down from US$11.3b a year prior. However, it also had US$202.0m in cash, and so its net debt is US$9.35b.
How Strong Is United Rentals’ Balance Sheet?
The latest balance sheet data shows that United Rentals had liabilities of US$1.89b due within a year, and liabilities of US$11.4b falling due after that. On the other hand, it had cash of US$202.0m and US$1.33b worth of receivables due within a year. So its liabilities total US$11.8b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since United Rentals has a huge market capitalization of US$23.5b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
United Rentals has a debt to EBITDA ratio of 4.1 and its EBIT covered its interest expense 3.9 times. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. Investors should also be troubled by the fact that United Rentals saw its EBIT drop by 16% over the last twelve months. If that’s the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if United Rentals can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, United Rentals generated free cash flow amounting to a very robust 82% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.
Neither United Rentals’s ability to grow 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. We think that United Rentals’s debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example – United Rentals has 2 warning signs we think you should be aware of.
At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.
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