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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.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies. Sterling Construction Company, Inc. (NASDAQ:STRL) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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 Sterling Construction Company’s Debt?
You can click the graphic below for the historical numbers, but it shows that Sterling Construction Company had US$77.3m of debt in March 2019, down from US$86.2m, one year before On the flip side, it has US$56.8m in cash leading to net debt of about US$20.6m.
A Look At Sterling Construction Company’s Liabilities
According to the last reported balance sheet, Sterling Construction Company had liabilities of US$162.0m due within 12 months, and liabilities of US$135.2m due beyond 12 months. Offsetting this, it had US$56.8m in cash and US$202.8m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$37.7m.
Of course, Sterling Construction Company has a market capitalization of US$369.0m, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Since Sterling Construction Company does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, over time.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Given net debt is only 0.46 times EBITDA, it is initially surprising to see that Sterling Construction Company’s EBIT has low interest coverage of 2.46 times. So one way or the other, it’s clear the debt levels are not trivial. We saw Sterling Construction Company grow its EBIT by 4.2% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. 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 Sterling Construction Company’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 two years, Sterling Construction Company recorded free cash flow of 44% of its EBIT, which is weaker than we’d expect. That’s not great, when it comes to paying down debt.
Sterling Construction Company’s interest cover was a real negative on this analysis, although the other factors we considered were considerably better In particular, we thought its net debt to EBITDA was a positive. When we consider all the factors mentioned above, we do feel a bit cautious about Sterling Construction Company’s use of debt. 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. We’d be motivated to research the stock further if we found out that Sterling Construction Company insiders have bought shares recently. If you would too, then you’re in luck, since today we’re sharing our list of reported insider transactions for free.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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.