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. We note that Cintas Corporation (NASDAQ:CTAS) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. 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, 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. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Cintas Carry?
As you can see below, Cintas had US$2.60b of debt, at May 2021, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has US$493.6m in cash leading to net debt of about US$2.11b.
How Strong Is Cintas’ Balance Sheet?
The latest balance sheet data shows that Cintas had liabilities of US$1.93b due within a year, and liabilities of US$2.61b falling due after that. On the other hand, it had cash of US$493.6m and US$924.0m worth of receivables due within a year. So its liabilities total US$3.13b more than the combination of its cash and short-term receivables.
Of course, Cintas has a titanic market capitalization of US$40.4b, so these liabilities are probably manageable. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Cintas has a low net debt to EBITDA ratio of only 1.3. And its EBIT easily covers its interest expense, being 14.2 times the size. So we’re pretty relaxed about its super-conservative use of debt. Also good is that Cintas grew its EBIT at 19% over the last year, further increasing its ability to manage debt. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Cintas’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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Cintas generated free cash flow amounting to a very robust 83% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.
Happily, Cintas’s impressive interest cover implies it has the upper hand on its debt. And that’s just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Considering this range of factors, it seems to us that Cintas is quite prudent with its debt, and the risks seem well managed. So the balance sheet looks pretty healthy, to us.