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.' 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. We note that CTS Corporation (NYSE:CTS) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
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 CTS's Debt?
As you can see below, CTS had US$108.8m of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. But it also has US$131.7m in cash to offset that, meaning it has US$23.0m net cash.
How Strong Is CTS's Balance Sheet?
The latest balance sheet data shows that CTS had liabilities of US$95.1m due within a year, and liabilities of US$146.8m falling due after that. Offsetting these obligations, it had cash of US$131.7m as well as receivables valued at US$76.4m due within 12 months. So it has liabilities totalling US$33.7m more than its cash and near-term receivables, combined.
Given CTS has a market capitalization of US$1.11b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, CTS also has more cash than debt, so we're pretty confident it can manage its debt safely.
The modesty of its debt load may become crucial for CTS if management cannot prevent a repeat of the 34% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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 CTS'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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. CTS may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, CTS 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.
We could understand if investors are concerned about CTS's liabilities, but we can be reassured by the fact it has has net cash of US$23.0m. And it impressed us with free cash flow of US$56m, being 75% of its EBIT. So we don't have any problem with CTS's use of debt. 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. Consider risks, for instance. Every company has them, and we've spotted 1 warning sign for CTS 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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