The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that CryoLife, Inc. (NYSE:CRY) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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 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. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is CryoLife’s Debt?
The image below, which you can click on for greater detail, shows that at March 2021 CryoLife had debt of US$311.2m, up from US$245.4m in one year. However, it also had US$56.6m in cash, and so its net debt is US$254.7m.
A Look At CryoLife’s Liabilities
According to the last reported balance sheet, CryoLife had liabilities of US$58.0m due within 12 months, and liabilities of US$439.5m due beyond 12 months. Offsetting these obligations, it had cash of US$56.6m as well as receivables valued at US$50.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$390.2m.
CryoLife has a market capitalization of US$1.07b, 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Weak interest cover of 0.61 times and a disturbingly high net debt to EBITDA ratio of 7.9 hit our confidence in CryoLife like a one-two punch to the gut. This means we’d consider it to have a heavy debt load. Worse, CryoLife’s EBIT was down 23% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if CryoLife can strengthen its balance sheet over time.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, CryoLife reported free cash flow worth 10% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
On the face of it, CryoLife’s interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to handle its total liabilities isn’t such a worry. It’s also worth noting that CryoLife is in the Medical Equipment industry, which is often considered to be quite defensive. We’re quite clear that we consider CryoLife to be really rather risky, as a result of its balance sheet health. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start.
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