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. We note that CNH Industrial N.V. (NYSE:CNHI) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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 examine debt levels, we first consider both cash and debt levels, together.

What Is CNH Industrial’s Debt?

As you can see below, at the end of December 2020, CNH Industrial had US$26.1b of debt, up from US$24.9b a year ago. Click the image for more detail. However, because it has a cash reserve of US$8.49b, its net debt is less, at about US$17.6b.

How Strong Is CNH Industrial’s Balance Sheet?

Zooming in on the latest balance sheet data, we can see that CNH Industrial had liabilities of US$21.8b due within 12 months and liabilities of US$21.9b due beyond that. On the other hand, it had cash of US$8.49b and US$506.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$34.7b.

The deficiency here weighs heavily on the US$21.2b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we’d watch its balance sheet closely, without a doubt. At the end of the day, CNH Industrial would probably need a major re-capitalization if its creditors were to demand repayment.

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.

With a net debt to EBITDA ratio of 11.5, it’s fair to say CNH Industrial does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 3.7 times, suggesting it can responsibly service its obligations. Worse, CNH Industrial’s EBIT was down 60% over the last year. If earnings keep going like that over the long term, it has a snowball’s chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if CNH Industrial 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 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. Over the last three years, CNH Industrial actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

To be frank both CNH Industrial’s EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it’s pretty decent at converting EBIT to free cash flow; that’s encouraging. We’re quite clear that we consider CNH Industrial to be really rather risky, as a result of its balance sheet health. So we’re almost as wary of this stock as a hungry kitten is about falling into its owner’s fish pond: once bitten, twice shy, as they say. 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. We’ve identified 1 warning sign with CNH Industrial , and understanding them should be part of your investment process.

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