Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. Importantly, Concrete Pumping Holdings, Inc. (NASDAQ:BBCP) does carry debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Concrete Pumping Holdings Carry?
The image below, which you can click on for greater detail, shows that Concrete Pumping Holdings had debt of US$375.7m at the end of January 2021, a reduction from US$416.2m over a year. And it doesn't have much cash, so its net debt is about the same.
How Strong Is Concrete Pumping Holdings' Balance Sheet?
According to the last reported balance sheet, Concrete Pumping Holdings had liabilities of US$40.3m due within 12 months, and liabilities of US$434.0m due beyond 12 months. Offsetting these obligations, it had cash of US$2.27m as well as receivables valued at US$40.6m due within 12 months. So its liabilities total US$431.5m more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company's US$412.8m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While we wouldn't worry about Concrete Pumping Holdings's net debt to EBITDA ratio of 4.1, we think its super-low interest cover of 0.95 times is a sign of high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. The good news is that Concrete Pumping Holdings improved its EBIT by 2.1% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. 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 Concrete Pumping Holdings'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Concrete Pumping Holdings recorded free cash flow of 44% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Mulling over Concrete Pumping Holdings's attempt at covering its interest expense with its EBIT, we're certainly not enthusiastic. Having said that, its ability to grow its EBIT isn't such a worry. Overall, we think it's fair to say that Concrete Pumping Holdings has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Concrete Pumping Holdings that you should be aware of.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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