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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Cornerstone OnDemand, Inc. (NASDAQ:CSOD) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Cornerstone OnDemand's Net Debt?
As you can see below, at the end of September 2020, Cornerstone OnDemand had US$1.23b of debt, up from US$292.1m a year ago. Click the image for more detail. However, it does have US$170.9m in cash offsetting this, leading to net debt of about US$1.06b.
How Strong Is Cornerstone OnDemand's Balance Sheet?
According to the last reported balance sheet, Cornerstone OnDemand had liabilities of US$513.3m due within 12 months, and liabilities of US$1.32b due beyond 12 months. Offsetting this, it had US$170.9m in cash and US$156.7m in receivables that were due within 12 months. So it has liabilities totalling US$1.51b more than its cash and near-term receivables, combined.
Cornerstone OnDemand has a market capitalization of US$3.03b, 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Cornerstone OnDemand shareholders face the double whammy of a high net debt to EBITDA ratio (12.3), and fairly weak interest coverage, since EBIT is just 0.57 times the interest expense. This means we'd consider it to have a heavy debt load. The silver lining is that Cornerstone OnDemand grew its EBIT by 477% last year, which nourishing like the idealism of youth. If that earnings trend continues it will make its debt load much more manageable in the future. 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 Cornerstone OnDemand'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.
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. Over the last two years, Cornerstone OnDemand actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
We weren't impressed with Cornerstone OnDemand's net debt to EBITDA, and its interest cover made us cautious. But like a ballerina ending on a perfect pirouette, it has not trouble converting EBIT to free cash flow. When we consider all the elements mentioned above, it seems to us that Cornerstone OnDemand 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. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Cornerstone OnDemand is showing 1 warning sign in our investment analysis , you should know about...
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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