Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ 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 Cabot Corporation (NYSE:CBT) makes use of debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Cabot’s Debt?
As you can see below, at the end of March 2019, Cabot had US$1.25b of debt, up from US$961.0m a year ago. Click the image for more detail. However, it does have US$176.0m in cash offsetting this, leading to net debt of about US$1.08b.
How Healthy Is Cabot’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Cabot had liabilities of US$1.13b due within 12 months and liabilities of US$907.0m due beyond that. Offsetting these obligations, it had cash of US$176.0m as well as receivables valued at US$555.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.31b.
This deficit isn’t so bad because Cabot is worth US$2.60b, 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.
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.
Cabot’s net debt of 2.0 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 8.1 times its interest expenses harmonizes with that theme. If Cabot can keep growing EBIT at last year’s rate of 12% over the last year, then it will find its debt load easier to manage. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Cabot’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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Cabot recorded free cash flow of 33% of its EBIT, which is weaker than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
Cabot’s interest cover was a real positive on this analysis, as was its EBIT growth rate. Having said that, its conversion of EBIT to free cash flow somewhat sensitizes us to potential future risks to the balance sheet. Looking at all this data makes us feel a little cautious about Cabot’s debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. Of course, we wouldn’t say no to the extra confidence that we’d gain if we knew that Cabot insiders have been buying shares: if you’re on the same wavelength, you can find out if insiders are buying by clicking this link.
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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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. Thank you for reading.