Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Eastman Chemical Company (NYSE:EMN) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Eastman Chemical's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Eastman Chemical had US$5.14b of debt in June 2024, down from US$5.51b, one year before. However, it also had US$530.0m in cash, and so its net debt is US$4.61b.

How Strong Is Eastman Chemical's Balance Sheet?

According to the last reported balance sheet, Eastman Chemical had liabilities of US$2.74b due within 12 months, and liabilities of US$6.51b due beyond 12 months. On the other hand, it had cash of US$530.0m and US$1.33b worth of receivables due within a year. So its liabilities total US$7.39b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Eastman Chemical has a huge market capitalization of US$12.5b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Eastman Chemical's debt is 2.9 times its EBITDA, and its EBIT cover its interest expense 5.2 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Unfortunately, Eastman Chemical saw its EBIT slide 2.3% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Eastman Chemical's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Eastman Chemical's free cash flow amounted to 38% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

While Eastman Chemical's level of total liabilities makes us cautious about it, its track record of managing its debt, based on its EBITDA, is no better. But its not so bad at covering its interest expense with its EBIT. When we consider all the factors discussed, it seems to us that Eastman Chemical is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. Be aware that Eastman Chemical is showing 2 warning signs in our investment analysis , you should know about...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.