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.' 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. We can see that Eagle Materials Inc. (NYSE:EXP) does use debt in its business. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.
What Is Eagle Materials's Debt?
The image below, which you can click on for greater detail, shows that Eagle Materials had debt of US$1.01b at the end of March 2021, a reduction from US$1.57b over a year. However, it does have US$263.5m in cash offsetting this, leading to net debt of about US$745.1m.
How Healthy Is Eagle Materials' Balance Sheet?
The latest balance sheet data shows that Eagle Materials had liabilities of US$169.4m due within a year, and liabilities of US$1.31b falling due after that. On the other hand, it had cash of US$263.5m and US$150.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.07b.
Given Eagle Materials has a market capitalization of US$5.70b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
With a debt to EBITDA ratio of 1.5, Eagle Materials uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 8.8 times its interest expenses harmonizes with that theme. Another good sign is that Eagle Materials has been able to increase its EBIT by 24% in twelve months, making it easier to pay down 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 Eagle Materials's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Eagle Materials actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
Eagle Materials's conversion of EBIT to free cash flow 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! Zooming out, Eagle Materials seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. 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. For example, we've discovered 2 warning signs for Eagle Materials 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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