The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. 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. We note that Copart, Inc. (NASDAQ:CPRT) does have debt on its balance sheet. 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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is Copart's Net Debt?
The chart below, which you can click on for greater detail, shows that Copart had US$401.2m in debt in July 2019; about the same as the year before. However, because it has a cash reserve of US$186.3m, its net debt is less, at about US$214.9m.
How Strong Is Copart's Balance Sheet?
According to the last reported balance sheet, Copart had liabilities of US$282.0m due within 12 months, and liabilities of US$487.2m due beyond 12 months. Offsetting this, it had US$186.3m in cash and US$106.0m in receivables that were due within 12 months. So its liabilities total US$477.0m more than the combination of its cash and short-term receivables.
Since publicly traded Copart shares are worth a very impressive total of US$18.9b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. But either way, Copart has virtually no net debt, so it's fair to say it does not have a heavy debt load!
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). 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).
Copart has a low net debt to EBITDA ratio of only 0.27. And its EBIT easily covers its interest expense, being 40.7 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The good news is that Copart has increased its EBIT by 9.5% over twelve months, which should ease any concerns about debt repayment. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Copart can strengthen its balance sheet over time. 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 we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Copart recorded free cash flow of 45% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Copart's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its net debt to EBITDA is also very heartening. When we consider the range of factors above, it looks like Copart is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. We'd be motivated to research the stock further if we found out that Copart insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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