Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. 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. We note that The Goodyear Tire & Rubber Company (NASDAQ:GT) has debt on its balance sheet. But the real question is whether this debt makes the business risky.

When is debt dangerous?

Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. If things go really bad, lenders can take over the business. 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, debt can be an important tool in businesses, especially capital-intensive businesses. When we think about a company’s use of debt, we first look at cash and debt together.

See our latest analysis for Goodyear Tire & Rubber

What is Goodyear Tire & Rubber’s net debt?

The image below, which you can click on for more details, shows that in March 2022, Goodyear Tire & Rubber had $8.13 billion in debt, up from $5.86 billion in one year. On the other hand, he has $1.05 billion in cash, resulting in a net debt of around $7.07 billion.

How healthy is Goodyear Tire & Rubber’s balance sheet?

We can see from the most recent balance sheet that Goodyear Tire & Rubber had liabilities of $6.95 billion due in one year, and liabilities of $10.4 billion beyond. In return, it had $1.05 billion in cash and $3.20 billion in receivables due within 12 months. It therefore has liabilities totaling $13.0 billion more than its cash and short-term receivables, combined.

This deficit casts a shadow over the $3.30 billion enterprise, like a colossus towering above mere mortals. So we definitely think shareholders need to watch this one closely. Ultimately, Goodyear Tire & Rubber would likely need a major recapitalization if its creditors were to demand repayment.

In order to assess a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its earnings before interest and taxes (EBIT) divided by its expenses. interest (its 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 ).

Goodyear Tire & Rubber has a debt to EBITDA ratio of 3.6 and its EBIT covered its interest expense 2.7 times. This suggests that while debt levels are significant, we will refrain from labeling them as problematic. The silver lining is that Goodyear Tire & Rubber grew its EBIT by 2,419% last year, which feeds like youthful idealism. If this earnings trend continues, it will make its leverage much more manageable in the future. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether Goodyear Tire & Rubber can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.

But our last consideration is also important, because a company cannot pay debt with paper profits; he needs cash. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Goodyear Tire & Rubber’s free cash flow has been 37% of its EBIT, less than we expected. It’s not great when it comes to paying off debt.

Our point of view

Reflecting on Goodyear Tire & Rubber’s attempt to rein in its total liabilities, we’re certainly not enthusiastic. But on the bright side, its EBIT growth rate is a good sign and makes us more optimistic. Looking at the big picture, it seems clear to us that Goodyear Tire & Rubber’s use of debt creates risks for the business. If all goes well, it can pay off, but the downside of this debt is a greater risk of permanent losses. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks reside on the balance sheet, far from it. For example, Goodyear Tire & Rubber has 3 warning signs (and 1 of concern) that we think you should know about.

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

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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.