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.’ 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. Importantly, ABM Industries Incorporated (NYSE:ABM) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does ABM Industries Carry?

You can click the graphic below for the historical numbers, but it shows that as of January 2022 ABM Industries had US$1.01b of debt, an increase on US$703.4m, over one year. However, it also had US$46.6m in cash, and so its net debt is US$959.3m.

A Look At ABM Industries’ Liabilities

According to the last reported balance sheet, ABM Industries had liabilities of US$1.27b due within 12 months, and liabilities of US$1.58b due beyond 12 months. Offsetting these obligations, it had cash of US$46.6m as well as receivables valued at US$1.28b due within 12 months. So its liabilities total US$1.52b more than the combination of its cash and short-term receivables.

This deficit isn’t so bad because ABM Industries is worth US$3.35b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

We’d say that ABM Industries’s moderate net debt to EBITDA ratio ( being 2.0), indicates prudence when it comes to debt. And its strong interest cover of 14.2 times, makes us even more comfortable. One way ABM Industries could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 11%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if ABM Industries 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, ABM Industries generated free cash flow amounting to a very robust 90% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.

Our View

The good news is that ABM Industries’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its level of total liabilities. When we consider the range of factors above, it looks like ABM Industries is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. 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.