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Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, CDW Corporation (NASDAQ:CDW) does carry debt. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is CDW’s Net Debt?
The chart below, which you can click on for greater detail, shows that CDW had US$3.78b in debt in March 2019; about the same as the year before. However, because it has a cash reserve of US$285.0m, its net debt is less, at about US$3.50b.
How Strong Is CDW’s Balance Sheet?
The latest balance sheet data shows that CDW had liabilities of US$3.22b due within a year, and liabilities of US$3.54b falling due after that. Offsetting these obligations, it had cash of US$285.0m as well as receivables valued at US$3.08b due within 12 months. So it has liabilities totalling US$3.39b more than its cash and near-term receivables, combined.
CDW has a very large market capitalization of US$16.9b, so it could very likely 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. Either way, since CDW does have more debt than cash, it’s worth keeping an eye on its balance sheet.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).
CDW has a debt to EBITDA ratio of 2.74 and its EBIT covered its interest expense 6.78 times. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. If CDW can keep growing EBIT at last year’s rate of 12% over the last year, then it will find its debt load easier to manage. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if CDW 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.
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 most recent three years, CDW recorded free cash flow worth 68% 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.
Happily, CDW’s impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its net debt to EBITDA. All these things considered, it appears that CDW can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it’s worth monitoring the balance sheet. Of course, we wouldn’t say no to the extra confidence that we’d gain if we knew that CDW insiders have been buying shares: if you’re on the same wavelength, you can find out if insiders are buying by clicking this link.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.