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.' 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, Carpenter Technology Corporation (NYSE:CRS) does carry debt. But the more important question is: how much risk is that debt creating?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.
How Much Debt Does Carpenter Technology Carry?
The chart below, which you can click on for greater detail, shows that Carpenter Technology had US$570.3m in debt in June 2019; about the same as the year before. However, it does have US$27.0m in cash offsetting this, leading to net debt of about US$543.3m.
A Look At Carpenter Technology's Liabilities
According to the last reported balance sheet, Carpenter Technology had liabilities of US$416.0m due within 12 months, and liabilities of US$1.25b due beyond 12 months. On the other hand, it had cash of US$27.0m and US$384.1m worth of receivables due within a year. So it has liabilities totalling US$1.26b more than its cash and near-term receivables, combined.
This deficit isn't so bad because Carpenter Technology is worth US$2.24b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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).
Carpenter Technology has net debt of just 1.5 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 9.3 times the interest expense over the last year. We note that Carpenter Technology grew its EBIT by 29% in the last year, and that should make it easier to pay down debt, going forward. 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 Carpenter Technology 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Carpenter Technology's free cash flow amounted to 30% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
When it comes to the balance sheet, the standout positive for Carpenter Technology was the fact that it seems able to grow its EBIT confidently. However, our other observations weren't so heartening. For example, its conversion of EBIT to free cash flow makes us a little nervous about its debt. When we consider all the elements mentioned above, it seems to us that Carpenter Technology is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. Over time, share prices tend to follow earnings per share, so if you're interested in Carpenter Technology, you may well want to click here to check an interactive graph of its earnings per share history.
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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