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.' 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 Crown Holdings, Inc. (NYSE:CCK) 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Crown Holdings's Net Debt?
The chart below, which you can click on for greater detail, shows that Crown Holdings had US$8.25b in debt in September 2020; about the same as the year before. On the flip side, it has US$613.0m in cash leading to net debt of about US$7.63b.
A Look At Crown Holdings' Liabilities
According to the last reported balance sheet, Crown Holdings had liabilities of US$3.62b due within 12 months, and liabilities of US$9.69b due beyond 12 months. Offsetting this, it had US$613.0m in cash and US$1.86b in receivables that were due within 12 months. So its liabilities total US$10.8b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its very significant market capitalization of US$12.6b, so it does suggest shareholders should keep an eye on Crown Holdings' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Crown Holdings's debt is 4.7 times its EBITDA, and its EBIT cover its interest expense 3.7 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Given the debt load, it's hardly ideal that Crown Holdings's EBIT was pretty flat over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Crown Holdings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Crown Holdings reported free cash flow worth 18% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
To be frank both Crown Holdings's level of total liabilities and its track record of managing its debt, based on its EBITDA, make us rather uncomfortable with its debt levels. Having said that, its ability to grow its EBIT isn't such a worry. Looking at the bigger picture, it seems clear to us that Crown Holdings's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Crown Holdings is showing 2 warning signs in our investment analysis , and 1 of those shouldn't be ignored...
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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What are the risks and opportunities for Crown Holdings?
Trading at 56.9% below our estimate of its fair value
Earnings are forecast to grow 17.18% per year
Debt is not well covered by operating cash flow
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