The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ 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 can see that Carpenter Technology Corporation (NYSE:CRS) does use debt in its business. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Carpenter Technology’s Net Debt?
The chart below, which you can click on for greater detail, shows that Carpenter Technology had US$570.3m in debt in June 2019; about the same as the year before. However, because it has a cash reserve of US$27.0m, its net debt is less, at about US$543.3m.
A Look At Carpenter Technology’s Liabilities
We can see from the most recent balance sheet that Carpenter Technology had liabilities of US$416.0m falling due within a year, and liabilities of US$1.25b due beyond that. Offsetting these obligations, it had cash of US$27.0m as well as receivables valued at US$384.1m due within 12 months. So it has liabilities totalling US$1.26b more than its cash and near-term receivables, combined.
This deficit isn’t so bad because Carpenter Technology is worth US$2.22b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Carpenter Technology has net debt of just 1.5 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 9.3 times, which is more than adequate. We note that Carpenter Technology grew its EBIT by 29% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Carpenter Technology 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. In the last three years, Carpenter Technology’s free cash flow amounted to 30% of its EBIT, less than we’d expect. That’s not great, when it comes to paying down debt.
On our analysis Carpenter Technology’s EBIT growth rate should signal that it won’t have too much trouble with its debt. However, our other observations weren’t so heartening. 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 Carpenter Technology is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. Over time, share prices tend to follow earnings per share, so if you’re interested in Carpenter Technology, you may well want to click here to check an interactive graph of its earnings per share history.
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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