Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk. 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. As with many other companies CSL Limited (ASX:CSL) makes use of debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 CSL's Net Debt?
As you can see below, at the end of June 2019, CSL had US$4.64b of debt, up from US$4.39b a year ago. Click the image for more detail. On the flip side, it has US$658.2m in cash leading to net debt of about US$3.98b.
How Healthy Is CSL's Balance Sheet?
The latest balance sheet data shows that CSL had liabilities of US$2.19b due within a year, and liabilities of US$4.87b falling due after that. Offsetting this, it had US$658.2m in cash and US$1.73b in receivables that were due within 12 months. So it has liabilities totalling US$4.68b more than its cash and near-term receivables, combined.
Given CSL has a humongous market capitalization of US$78.0b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
CSL's net debt is only 1.4 times its EBITDA. And its EBIT easily covers its interest expense, being 22.0 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 CSL has increased its EBIT by 5.2% 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 CSL 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, while the tax-man may adore accounting profits, lenders only accept 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, CSL recorded free cash flow of 25% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Happily, CSL's impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. All these things considered, it appears that CSL can comfortably handle its current debt levels. 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. Over time, share prices tend to follow earnings per share, so if you're interested in CSL, you may well want to click here to check an interactive graph of its earnings per share history.
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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