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. 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. Importantly, Cabot Corporation (NYSE:CBT) does carry debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is Cabot's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Cabot had debt of US$1.11b, up from US$1.00b in one year. However, it also had US$147.0m in cash, and so its net debt is US$959.0m.
How Strong Is Cabot's Balance Sheet?
According to the last reported balance sheet, Cabot had liabilities of US$645.0m due within 12 months, and liabilities of US$1.25b due beyond 12 months. Offsetting these obligations, it had cash of US$147.0m as well as receivables valued at US$611.0m due within 12 months. So its liabilities total US$1.14b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Cabot has a market capitalization of US$2.58b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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.
Cabot's net debt of 1.9 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 7.8 times its interest expenses harmonizes with that theme. Unfortunately, Cabot saw its EBIT slide 2.4% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Cabot'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.
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, Cabot recorded free cash flow of 30% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Neither Cabot's ability to convert EBIT to free cash flow nor its EBIT growth rate gave us confidence in its ability to take on more debt. But we do take some comfort from its interest cover. Looking at all the angles mentioned above, it does seem to us that Cabot is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. Given Cabot has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly 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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