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, Crane Co. (NYSE:CR) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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 step when considering a company's debt levels is to consider its cash and debt together.
What Is Crane's Debt?
You can click the graphic below for the historical numbers, but it shows that Crane had US$948.1m of debt in June 2019, down from US$1.11b, one year before. However, it also had US$307.0m in cash, and so its net debt is US$641.1m.
How Strong Is Crane's Balance Sheet?
The latest balance sheet data shows that Crane had liabilities of US$634.6m due within a year, and liabilities of US$1.83b falling due after that. On the other hand, it had cash of US$307.0m and US$618.2m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.54b.
This deficit isn't so bad because Crane is worth US$4.69b, 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.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Crane has a low net debt to EBITDA ratio of only 1.1. And its EBIT covers its interest expense a whopping 10.6 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. And we also note warmly that Crane grew its EBIT by 11% last year, making its debt load easier to handle. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Crane 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Crane recorded free cash flow worth 64% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
The good news is that Crane's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Looking at all the aforementioned factors together, it strikes us that Crane can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Crane insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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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