British American Tobacco (LON: BATS) has a somewhat strained record

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Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from risk.” So it can be obvious that you need to consider debt, when you think about how risky a given stock is, because too much debt can sink a business. Like many other companies British American Tobacco plc (LON: BATS) uses debt. But the real question is whether this debt makes the business risky.

When Is Debt a Problem?

Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. Ultimately, if the company can’t meet its legal debt repayment obligations, shareholders could walk away with nothing. 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. Of course, many companies use debt to finance their growth without negative consequences. The first step in examining a company’s debt levels is to consider its cash flow and debt together.

Check out our latest review for British American Tobacco

What is British American Tobacco’s net debt?

As you can see below, British American Tobacco was in debt of £ 44.6bn in June 2021, up from £ 50.5bn the year before. However, with a cash reserve of £ 3.35bn, his net debt is lower, at around £ 41.2bn.

LSE: BATS History of debt to equity October 14, 2021

Is British American Tobacco’s track record healthy?

The latest balance sheet data shows British American Tobacco had a liability of £ 18.4 billion due within one year, and a liability of £ 55.4 billion due after that. In compensation for these obligations, it had cash of £ 3.35 billion as well as receivables valued at £ 4.08 billion maturing within 12 months. Its liabilities therefore total £ 66.4 billion more than the combination of its cash and short-term receivables.

Given that this deficit is actually greater than the company’s massive market cap of £ 58.8 billion, we think shareholders should really watch British American Tobacco debt levels, like a parent watching. her child riding a bicycle for the first time. Hypothetically, an extremely large dilution would be required if the company was forced to repay its debts by raising capital at the current share price.

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).

British American Tobacco’s debt is 3.4 times its EBITDA, and its EBIT covers its interest expense 6.2 times. This suggests that while debt levels are significant, we would stop calling them problematic. Notably, British American Tobacco’s EBIT has been fairly stable over the past year. Ideally, he can reduce his debt load by starting profit growth. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future profits, more than anything, that will determine British American Tobacco’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, while the IRS may love accounting profits, lenders only accept hard cash. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, British American Tobacco has generated strong free cash flow equivalent to 78% of its EBIT, roughly what we expected. This hard cash allows him to reduce his debt whenever he wants.

Our point of view

British American Tobacco’s level of total liabilities and net debt to EBITDA certainly weighs on this, in our view. But his conversion from EBIT to free cash tells a very different story and suggests some resilience. We think British American Tobacco’s debt makes it a bit risky, having considered the aforementioned data points together. This isn’t necessarily a bad thing, as leverage can increase returns on equity, but it’s something to be aware of. 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. These risks can be difficult to spot. Every business has them, and we’ve spotted 2 warning signs for British American Tobacco (1 of which should not be ignored!) that you should know.

If you are interested in investing in companies that can generate profits without the burden of debt, check out this page free list of growing companies that have net cash on the balance sheet.

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 any of the stocks mentioned.

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