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 CRA International, Inc. (NASDAQ:CRAI) does use debt in its business. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does CRA International Carry?
The image below, which you can click on for greater detail, shows that at September 2019 CRA International had debt of US$36.0m, up from US$5.0 in one year. However, because it has a cash reserve of US$19.8m, its net debt is less, at about US$16.2m.
How Healthy Is CRA International’s Balance Sheet?
According to the last reported balance sheet, CRA International had liabilities of US$172.2m due within 12 months, and liabilities of US$141.0m due beyond 12 months. Offsetting these obligations, it had cash of US$19.8m as well as receivables valued at US$149.6m due within 12 months. So it has liabilities totalling US$143.8m more than its cash and near-term receivables, combined.
CRA International has a market capitalization of US$415.1m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
CRA International has a low net debt to EBITDA ratio of only 0.39. And its EBIT covers its interest expense a whopping 30.3 times over. So we’re pretty relaxed about its super-conservative use of debt. In addition to that, we’re happy to report that CRA International has boosted its EBIT by 45%, thus reducing the spectre of future debt repayments. 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. For example, we’ve discovered 1 warning sign for CRA International which any shareholder or potential investor should be aware of.
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. Over the most recent three years, CRA International recorded free cash flow worth 74% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Happily, CRA International’s impressive interest cover implies it has the upper hand on its debt. And that’s just the beginning of the good news since its EBIT growth rate is also very heartening. Looking at the bigger picture, we think CRA International’s use of debt seems quite reasonable and we’re not concerned about it. After all, sensible leverage can boost returns on equity. Another factor that would give us confidence in CRA International would be if insiders have been buying shares: if you’re conscious of that signal too, you can find out instantly by clicking this link.
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.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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