Is Cabot (NYSE:CBT) A Risky Investment?

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. Importantly, Cabot Corporation (NYSE:CBT) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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.

View our latest analysis for Cabot

What Is Cabot's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2022 Cabot had US$1.41b of debt, an increase on US$1.13b, over one year. However, because it has a cash reserve of US$206.0m, its net debt is less, at about US$1.21b.

How Strong Is Cabot's Balance Sheet?

We can see from the most recent balance sheet that Cabot had liabilities of US$1.11b falling due within a year, and liabilities of US$1.39b due beyond that. Offsetting this, it had US$206.0m in cash and US$840.0m in receivables that were due within 12 months. So its liabilities total US$1.45b more than the combination of its cash and short-term receivables.

Cabot has a market capitalization of US$3.79b, so it could very likely raise cash to ameliorate 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 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 Cabot's moderate net debt to EBITDA ratio ( being 1.7), indicates prudence when it comes to debt. And its commanding EBIT of 12.4 times its interest expense, implies the debt load is as light as a peacock feather. We note that Cabot grew its EBIT by 29% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Cabot 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Cabot reported free cash flow worth 11% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Cabot's interest cover was a real positive on this analysis, as was its EBIT growth rate. On the other hand, its conversion of EBIT to free cash flow makes us a little less comfortable about its debt. When we consider all the elements mentioned above, it seems to us that Cabot is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 4 warning signs with Cabot (at least 1 which is concerning) , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.