Here’s Why Canadian Pacific Railway (TSE:CP) Has a Heavy Debt Burden

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Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. We note that Canadian Pacific Railway Limited (TSE:CP) has debt on its balance sheet. But does this debt worry shareholders?

When is debt a problem?

Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. In the worst case, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. The first thing to do when considering how much debt a business has is to look at its cash and debt together.

Check out our latest analysis for Canadian Pacific Railway

What is Canadian Pacific Railway’s debt?

As you can see below, at the end of June 2022, the Canadian Pacific Railway had a debt of 20.1 billion Canadian dollars, compared to 8.80 billion Canadian dollars a year ago. Click on the image for more details. Net debt is about the same, since she doesn’t have a lot of cash.

TSX:CP Debt to Equity Historical September 20, 2022

How healthy is Canadian Pacific Railway’s balance sheet?

The latest balance sheet data shows that Canadian Pacific Railway had liabilities of C$3.21 billion due within one year, and liabilities of C$31.3 billion falling due thereafter. . In return, he had C$154.0 million in cash and C$962.0 million in receivables due within 12 months. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables of C$33.3 billion.

While that might sound like a lot, it’s not that bad since Canadian Pacific Railway has a huge market capitalization of C$91.4 billion, and so it could likely bolster its balance sheet by raising capital if needed. But it is clear that it is essential to examine closely whether it can manage its debt without dilution.

We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.

Canadian Pacific Railway’s debt is 4.6 times its EBITDA, and its EBIT covers its interest expense 6.4 times. Taken together, this implies that, while we wouldn’t like to see debt levels increase, we think he can manage his current leverage. Unfortunately, Canadian Pacific Railway’s EBIT actually fell 8.0% over the past year. If earnings continue to fall, managing that debt will be as difficult as delivering hot soup on a unicycle. There is no doubt that we learn the most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Canadian Pacific Railway’s ability to maintain a healthy balance sheet in the future. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.

Finally, a business needs free cash flow to pay off its debts; book profits are not enough. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Canadian Pacific Railway has recorded free cash flow of 44% of its EBIT, which is lower than expected. This low cash conversion makes debt management more difficult.

Our point of view

Canadian Pacific Railway’s net debt to EBITDA was a real negative in this analysis, although the other factors we considered cast it in a significantly better light. For example, its interest coverage is relatively strong. Considering all the factors discussed, it seems to us that Canadian Pacific Railway is taking risks with its use of debt. So even if this leverage increases return on equity, we wouldn’t really want to see it increase from now on. The balance sheet is clearly the area to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist outside of the balance sheet. Example: we have identified 2 warning signs for the Canadian Pacific Railway you need to be aware of, and 1 of them should not be ignored.

Of course, if you’re the type of investor who prefers to buy stocks without the burden of debt, then feel free to check out our exclusive list of cash-efficient growth stocks today.

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.

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