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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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Heritage-Crystal Clean, Inc (NASDAQ:HCCI) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 Heritage-Crystal Clean's Net Debt?
As you can see below, Heritage-Crystal Clean had US$29.6m of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. However, its balance sheet shows it holds US$52.7m in cash, so it actually has US$23.1m net cash.
A Look At Heritage-Crystal Clean's Liabilities
Zooming in on the latest balance sheet data, we can see that Heritage-Crystal Clean had liabilities of US$72.0m due within 12 months and liabilities of US$110.8m due beyond that. Offsetting this, it had US$52.7m in cash and US$48.9m in receivables that were due within 12 months. So it has liabilities totalling US$81.2m more than its cash and near-term receivables, combined.
Given Heritage-Crystal Clean has a market capitalization of US$488.4m, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, Heritage-Crystal Clean also has more cash than debt, so we're pretty confident it can manage its debt safely.
In fact Heritage-Crystal Clean's saving grace is its low debt levels, because its EBIT has tanked 36% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Heritage-Crystal Clean can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Heritage-Crystal Clean has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Heritage-Crystal Clean produced sturdy free cash flow equating to 71% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Although Heritage-Crystal Clean's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$23.1m. And it impressed us with free cash flow of US$8.9m, being 71% of its EBIT. So we don't have any problem with Heritage-Crystal Clean's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with Heritage-Crystal Clean , and understanding them should be part of your investment process.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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