These 4 Measures Indicate That Construction Partners (NASDAQ:ROAD) Is Using Debt Extensively

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Construction Partners, Inc. (NASDAQ:ROAD) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Construction Partners

What Is Construction Partners's Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2022 Construction Partners had US$425.5m of debt, an increase on US$284.1m, over one year. However, because it has a cash reserve of US$43.2m, its net debt is less, at about US$382.3m.

A Look At Construction Partners' Liabilities

According to the last reported balance sheet, Construction Partners had liabilities of US$202.9m due within 12 months, and liabilities of US$467.3m due beyond 12 months. Offsetting this, it had US$43.2m in cash and US$262.9m in receivables that were due within 12 months. So it has liabilities totalling US$364.0m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Construction Partners is worth US$1.40b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

While we wouldn't worry about Construction Partners's net debt to EBITDA ratio of 4.0, we think its super-low interest cover of 2.5 times is a sign of high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Investors should also be troubled by the fact that Construction Partners saw its EBIT drop by 13% over the last twelve months. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. 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 Construction Partners'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Construction Partners created free cash flow amounting to 9.8% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

To be frank both Construction Partners's EBIT growth rate and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. But at least its level of total liabilities is not so bad. Overall, we think it's fair to say that Construction Partners 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. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Construction Partners has 2 warning signs (and 1 which is concerning) we think you should know about.

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.