Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Southwest Airlines Co. (NYSE:LUV) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.
What Is Southwest Airlines's Net Debt?
As you can see below, Southwest Airlines had US$7.97b of debt, at March 2024, which is about the same as the year before. You can click the chart for greater detail. But it also has US$10.5b in cash to offset that, meaning it has US$2.54b net cash.
How Strong Is Southwest Airlines' Balance Sheet?
We can see from the most recent balance sheet that Southwest Airlines had liabilities of US$12.2b falling due within a year, and liabilities of US$13.6b due beyond that. Offsetting these obligations, it had cash of US$10.5b as well as receivables valued at US$1.35b due within 12 months. So its liabilities total US$14.0b more than the combination of its cash and short-term receivables.
This is a mountain of leverage even relative to its gargantuan market capitalization of US$16.7b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. Despite its noteworthy liabilities, Southwest Airlines boasts net cash, so it's fair to say it does not have a heavy debt load!
But the bad news is that Southwest Airlines has seen its EBIT plunge 19% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Southwest Airlines 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, a company can only pay off debt with cold hard cash, not accounting profits. While Southwest Airlines has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last two years, Southwest Airlines saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
Summing Up
Although Southwest Airlines's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$2.54b. Despite the cash, we do find Southwest Airlines's conversion of EBIT to free cash flow concerning, so we're not particularly comfortable with the stock. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 3 warning signs for Southwest Airlines you should be aware of, and 1 of them is concerning.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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.