Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Valvoline Inc. (NYSE:VVV) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

How Much Debt Does Valvoline Carry?

As you can see below, Valvoline had US$1.58b of debt, at March 2024, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$497.8m in cash, and so its net debt is US$1.08b.

How Healthy Is Valvoline's Balance Sheet?

We can see from the most recent balance sheet that Valvoline had liabilities of US$963.7m falling due within a year, and liabilities of US$1.74b due beyond that. On the other hand, it had cash of US$497.8m and US$109.6m worth of receivables due within a year. So it has liabilities totalling US$2.10b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Valvoline has a market capitalization of US$5.41b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

With net debt to EBITDA of 2.5 Valvoline has a fairly noticeable amount of debt. On the plus side, its EBIT was 9.4 times its interest expense, and its net debt to EBITDA, was quite high, at 2.5. It is well worth noting that Valvoline's EBIT shot up like bamboo after rain, gaining 74% in the last twelve months. That'll make it easier to manage its debt. 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 Valvoline 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Valvoline created free cash flow amounting to 16% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

On our analysis Valvoline's EBIT growth rate should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For example, its conversion of EBIT to free cash flow makes us a little nervous about its debt. When we consider all the elements mentioned above, it seems to us that Valvoline is managing its debt quite well. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 3 warning signs for Valvoline that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.