Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ 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. We note that ArcBest Corporation (NASDAQ:ARCB) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does ArcBest Carry?
The image below, which you can click on for greater detail, shows that ArcBest had debt of US$226.0m at the end of December 2021, a reduction from US$285.8m over a year. However, it also had US$125.0m in cash, and so its net debt is US$101.0m.
A Look At ArcBest’s Liabilities
According to the last reported balance sheet, ArcBest had liabilities of US$702.7m due within 12 months, and liabilities of US$480.9m due beyond 12 months. On the other hand, it had cash of US$125.0m and US$595.4m worth of receivables due within a year. So its liabilities total US$463.2m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since ArcBest has a market capitalization of US$2.28b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). 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).
ArcBest’s net debt is only 0.26 times its EBITDA. And its EBIT covers its interest expense a whopping 35.6 times over. So we’re pretty relaxed about its super-conservative use of debt. Better yet, ArcBest grew its EBIT by 186% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine ArcBest’s ability to maintain a healthy balance sheet going forward.
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. Happily for any shareholders, ArcBest actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Our View
The good news is that ArcBest’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Considering this range of factors, it seems to us that ArcBest is quite prudent with its debt, and the risks seem well managed. So the balance sheet looks pretty healthy, to us. There’s no doubt that we learn most about debt from the balance sheet.