David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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, Compass Minerals International, Inc. (NYSE:CMP) 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. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
What Is Compass Minerals International's Debt?
The image below, which you can click on for greater detail, shows that Compass Minerals International had debt of US$922.2m at the end of March 2022, a reduction from US$1.18b over a year. On the flip side, it has US$44.9m in cash leading to net debt of about US$877.3m.
A Look At Compass Minerals International's Liabilities
The latest balance sheet data shows that Compass Minerals International had liabilities of US$224.2m due within a year, and liabilities of US$1.14b falling due after that. Offsetting these obligations, it had cash of US$44.9m as well as receivables valued at US$197.3m due within 12 months. So it has liabilities totalling US$1.12b more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of US$1.17b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Weak interest cover of 0.97 times and a disturbingly high net debt to EBITDA ratio of 5.2 hit our confidence in Compass Minerals International like a one-two punch to the gut. The debt burden here is substantial. Even worse, Compass Minerals International saw its EBIT tank 67% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Compass Minerals International 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 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. Over the most recent three years, Compass Minerals International recorded free cash flow worth 75% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
On the face of it, Compass Minerals International's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Overall, it seems to us that Compass Minerals International's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For example, we've discovered 3 warning signs for Compass Minerals International (1 is concerning!) that you should be aware of before investing here.
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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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.