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 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. As with many other companies Caesarstone Ltd. (NASDAQ:CSTE) makes use of debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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 Caesarstone Carry?
You can click the graphic below for the historical numbers, but it shows that as of December 2020 Caesarstone had US$23.5m of debt, an increase on US$6.84m, over one year. But on the other hand it also has US$122.4m in cash, leading to a US$98.9m net cash position.
How Healthy Is Caesarstone's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Caesarstone had liabilities of US$157.0m due within 12 months and liabilities of US$168.9m due beyond that. On the other hand, it had cash of US$122.4m and US$111.3m worth of receivables due within a year. So its liabilities total US$92.2m more than the combination of its cash and short-term receivables.
Caesarstone has a market capitalization of US$428.7m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. Despite its noteworthy liabilities, Caesarstone boasts net cash, so it's fair to say it does not have a heavy debt load!
Shareholders should be aware that Caesarstone's EBIT was down 23% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Caesarstone can strengthen its balance sheet over time. 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. Caesarstone may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Caesarstone produced sturdy free cash flow equating to 74% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Although Caesarstone's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$98.9m. The cherry on top was that in converted 74% of that EBIT to free cash flow, bringing in US$28m. So we are not troubled with Caesarstone's debt use. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Caesarstone (at least 1 which is concerning) , and understanding them should be part of your investment process.
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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