Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ 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. Importantly, Clean Harbors, Inc. (NYSE:CLH) does carry debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 Clean Harbors Carry?

The image below, which you can click on for greater detail, shows that Clean Harbors had debt of US$1.58b at the end of June 2021, a reduction from US$1.67b over a year. However, because it has a cash reserve of US$666.3m, its net debt is less, at about US$914.6m.

How Strong Is Clean Harbors’ Balance Sheet?

The latest balance sheet data shows that Clean Harbors had liabilities of US$711.1m due within a year, and liabilities of US$2.16b falling due after that. On the other hand, it had cash of US$666.3m and US$718.8m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.48b.

While this might seem like a lot, it is not so bad since Clean Harbors has a market capitalization of US$5.48b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Clean Harbors’s net debt is sitting at a very reasonable 1.6 times its EBITDA, while its EBIT covered its interest expense just 3.9 times last year. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. We note that Clean Harbors grew its EBIT by 29% in the last year, and that should make it easier to pay down debt, going forward. 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 Clean Harbors can strengthen its balance sheet over time.

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. Over the last three years, Clean Harbors actually produced more free cash flow than EBIT. There’s nothing better than incoming cash when it comes to staying in your lenders’ good graces.

Our View

The good news is that Clean Harbors’s demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But truth be told we feel its interest cover does undermine this impression a bit. Taking all this data into account, it seems to us that Clean Harbors takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet.