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.’ So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. We note that Norfolk Southern Corporation (NYSE:NSC) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
See our latest analysis for Norfolk Southern
What Is Norfolk Southern’s Net Debt?
As you can see below, at the end of September 2022, Norfolk Southern had US$15.6b of debt, up from US$14.4b a year ago. Click the image for more detail. However, it does have US$1.21b in cash offsetting this, leading to net debt of about US$14.4b.
A Look At Norfolk Southern’s Liabilities
According to the last reported balance sheet, Norfolk Southern had liabilities of US$2.80b due within 12 months, and liabilities of US$23.5b due beyond 12 months. On the other hand, it had cash of US$1.21b and US$1.15b worth of receivables due within a year. So its liabilities total US$23.9b more than the combination of its cash and short-term receivables.
Norfolk Southern has a very large market capitalization of US$60.0b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With a debt to EBITDA ratio of 2.4, Norfolk Southern uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 7.2 times its interest expenses harmonizes with that theme. One way Norfolk Southern could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 11%, as it did over the last year. 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 Norfolk Southern can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Norfolk Southern recorded free cash flow worth 58% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Our View
Both Norfolk Southern’s ability to to convert EBIT to free cash flow and its EBIT growth rate gave us comfort that it can handle its debt. Having said that, its net debt to EBITDA somewhat sensitizes us to potential future risks to the balance sheet. Considering this range of data points, we think Norfolk Southern is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it. For example, we’ve discovered 2 warning signs for Norfolk Southern that you should be aware of before investing here.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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Find out whether Norfolk Southern is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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