Warren Buffett said: “Volatility is far from synonymous with risk”. When we think about how risky a business is, we always like to look at its use of debt because debt overload can lead to bankruptcy. Like many other companies Union Pacific Corporation (NYSE: UNP) uses debt. But the most important question is: what risk does this debt create?
Why Does Debt Bring Risk?
Debts and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. That said, the most common situation is where a business manages its debt reasonably well – and to its own advantage. When we think of a business’s use of debt, we first look at cash flow and debt together.
What is Union Pacific’s net debt?
You can click on the graph below for historical numbers, but it shows that as of September 2021, Union Pacific had $ 29.0 billion in debt, an increase from $ 27.6 billion, on a year. However, he also had $ 1.24 billion in cash, so his net debt is $ 27.7 billion.
NYSE: UNP Debt to Equity History November 5, 2021
A look at Union Pacific’s liabilities
We can see from the most recent balance sheet that Union Pacific had liabilities of US $ 5.11 billion maturing within one year and liabilities of US $ 43.3 billion maturing within one year. of the. In return, he had $ 1.24 billion in cash and $ 1.68 billion in receivables due within 12 months. Its liabilities therefore total $ 45.5 billion more than the combination of its cash and short-term receivables.
Union Pacific has a very large market capitalization of US $ 152.5 billion, so it could most likely raise funds to improve its balance sheet, should the need arise. However, it is always worth taking a close look at your ability to repay your debt.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt versus EBITDA) and the actual interest charges associated with this debt (with its coverage rate). interests).
With a debt to EBITDA ratio of 2.5, Union Pacific uses debt smartly but responsibly. And the fact that her last twelve months of EBIT was 7.9 times her interest expense ties in with that theme. One way for Union Pacific to beat its debt would be to stop borrowing more but continue to increase its EBIT by around 12%, as it did last year. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether Union Pacific can strengthen its balance sheet over time. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
But our last consideration is also important, because a business cannot pay its debts with paper profits; he needs hard cash. The logical step is therefore to examine the proportion of this EBIT that corresponds to the actual free cash flow. Over the past three years, Union Pacific has recorded free cash flow of 65% of its EBIT, which is close to normal given that free cash flow excludes interest and taxes. This hard cash allows him to reduce his debt whenever he wants.
Our point of view
The good news is Union Pacific’s demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But frankly, we think its net debt to EBITDA undermines that impression a bit. Looking at all of the aforementioned factors together, it seems to us that Union Pacific can manage its debt quite comfortably. Of course, while this leverage can improve returns on equity, it brings more risk, so it’s worth keeping an eye out for. The balance sheet is clearly the area you need to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist off the balance sheet. We have identified 1 warning sign with Union Pacific and understanding them should be part of your investment process.
At the end of the day, sometimes it’s easier to focus on businesses that don’t even need to go into debt. Readers can access a list of growth stocks with zero net debt 100% free, at present.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in the mentioned stocks.
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