Is Caterpillar (NYSE:CAT) A Risky Investment?

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, Caterpillar Inc. (NYSE:CAT) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Caterpillar

What Is Caterpillar's Debt?

As you can see below, Caterpillar had US$37.9b of debt, at March 2024, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$4.36b in cash, and so its net debt is US$33.5b.

How Healthy Is Caterpillar's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Caterpillar had liabilities of US$32.4b due within 12 months and liabilities of US$33.7b due beyond that. Offsetting these obligations, it had cash of US$4.36b as well as receivables valued at US$9.49b due within 12 months. So its liabilities total US$52.2b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Caterpillar is worth a massive US$172.0b, and thus could probably raise enough capital to shore up 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.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

We'd say that Caterpillar's moderate net debt to EBITDA ratio ( being 2.1), indicates prudence when it comes to debt. And its commanding EBIT of 1k times its interest expense, implies the debt load is as light as a peacock feather. Also relevant is that Caterpillar has grown its EBIT by a very respectable 25% in the last year, thus enhancing its ability to pay down debt. 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 Caterpillar'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 we always check how much of that EBIT is translated into free cash flow. During the last three years, Caterpillar produced sturdy free cash flow equating to 59% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Caterpillar's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And the good news does not stop there, as its EBIT growth rate also supports that impression! Taking all this data into account, it seems to us that Caterpillar takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Caterpillar is showing 2 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

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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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.