David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. Importantly, CECO Environmental Corp. (NASDAQ:CECE) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.
What Is CECO Environmental's Debt?
You can click the graphic below for the historical numbers, but it shows that CECO Environmental had US$75.0m of debt in June 2019, down from US$86.2m, one year before. However, because it has a cash reserve of US$28.8m, its net debt is less, at about US$46.2m.
A Look At CECO Environmental's Liabilities
According to the last reported balance sheet, CECO Environmental had liabilities of US$99.6m due within 12 months, and liabilities of US$109.6m due beyond 12 months. Offsetting these obligations, it had cash of US$28.8m as well as receivables valued at US$92.2m due within 12 months. So its liabilities total US$88.1m more than the combination of its cash and short-term receivables.
CECO Environmental has a market capitalization of US$261.6m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While CECO Environmental's low debt to EBITDA ratio of 1.5 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.0 last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Pleasingly, CECO Environmental is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 274% gain in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine CECO Environmental'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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, CECO Environmental produced sturdy free cash flow equating to 66% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
The good news is that CECO Environmental's demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its interest cover. Looking at all the aforementioned factors together, it strikes us that CECO Environmental can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that CECO Environmental 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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