Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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. As with many other companies Builders FirstSource, Inc. (NYSE:BLDR) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. 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. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Builders FirstSource’s Net Debt?
The image below, which you can click on for greater detail, shows that at September 2021 Builders FirstSource had debt of US$2.42b, up from US$1.58b in one year. However, it does have US$224.7m in cash offsetting this, leading to net debt of about US$2.19b.
How Strong Is Builders FirstSource’s Balance Sheet?
We can see from the most recent balance sheet that Builders FirstSource had liabilities of US$2.03b falling due within a year, and liabilities of US$3.25b due beyond that. Offsetting these obligations, it had cash of US$224.7m as well as receivables valued at US$2.30b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.76b.
Since publicly traded Builders FirstSource shares are worth a very impressive total of US$14.1b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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).
Builders FirstSource has a low net debt to EBITDA ratio of only 0.90. And its EBIT easily covers its interest expense, being 16.9 times the size. So we’re pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that Builders FirstSource grew its EBIT by 395% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. 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 Builders FirstSource can strengthen its balance sheet over time.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. During the last three years, Builders FirstSource produced sturdy free cash flow equating to 54% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
Our View
Happily, Builders FirstSource’s impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its EBIT growth rate also supports that impression! Zooming out, Builders FirstSource seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. The balance sheet is clearly the area to focus on when you are analysing debt.