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. Importantly, Carriage Services, Inc. (NYSE:CSV) does carry debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 Carriage Services’s Net Debt?
The image below, which you can click on for greater detail, shows that at June 2022 Carriage Services had debt of US$572.9m, up from US$458.5m in one year. And it doesn’t have much cash, so its net debt is about the same.
A Look At Carriage Services’ Liabilities
Zooming in on the latest balance sheet data, we can see that Carriage Services had liabilities of US$42.8m due within 12 months and liabilities of US$985.7m due beyond that. On the other hand, it had cash of US$1.06m and US$24.7m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.00b.
This deficit casts a shadow over the US$451.1m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Carriage Services would likely require a major re-capitalisation if it had to pay its creditors today.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With a net debt to EBITDA ratio of 5.1, it’s fair to say Carriage Services does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 4.2 times, suggesting it can responsibly service its obligations. Given the debt load, it’s hardly ideal that Carriage Services’s EBIT was pretty flat over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Carriage Services’s ability to maintain a healthy balance sheet going forward.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Carriage Services recorded free cash flow worth 65% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Our View
To be frank both Carriage Services’s net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it’s pretty decent at converting EBIT to free cash flow; that’s encouraging. Overall, we think it’s fair to say that Carriage Services has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. The balance sheet is clearly the area to focus on when you are analysing debt.