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.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Core Laboratories N.V. (NYSE:CLB) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. 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 examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Core Laboratories Carry?

The image below, which you can click on for greater detail, shows that Core Laboratories had debt of US$261.9m at the end of December 2020, a reduction from US$306.3m over a year. However, because it has a cash reserve of US$13.8m, its net debt is less, at about US$248.1m.

How Healthy Is Core Laboratories’ Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Core Laboratories had liabilities of US$89.8m due within 12 months and liabilities of US$403.3m due beyond that. Offsetting this, it had US$13.8m in cash and US$92.9m in receivables that were due within 12 months. So its liabilities total US$386.3m more than the combination of its cash and short-term receivables.

This deficit isn’t so bad because Core Laboratories is worth US$1.26b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Core Laboratories’s debt is 3.5 times its EBITDA, and its EBIT cover its interest expense 3.5 times over. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. Even worse, Core Laboratories saw its EBIT tank 51% over the last 12 months. If earnings keep going like that over the long term, it has a snowball’s chance in hell of paying off that debt. 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 Core Laboratories can strengthen its balance sheet over time.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Core Laboratories produced sturdy free cash flow equating to 74% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Core Laboratories’s EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. In particular, its conversion of EBIT to free cash flow was re-invigorating. Taking the abovementioned factors together we do think Core Laboratories’s debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet.