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. Importantly, Cornerstone Building Brands, Inc. (NYSE:CNR) does carry debt. 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. 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. When we think about a company’s use of debt, we first look at cash and debt together.

What Is Cornerstone Building Brands’s Net Debt?

As you can see below, Cornerstone Building Brands had US$3.12b of debt at October 2021, down from US$3.68b a year prior. However, because it has a cash reserve of US$677.2m, its net debt is less, at about US$2.44b.

A Look At Cornerstone Building Brands’ Liabilities

The latest balance sheet data shows that Cornerstone Building Brands had liabilities of US$817.9m due within a year, and liabilities of US$3.80b falling due after that. Offsetting these obligations, it had cash of US$677.2m as well as receivables valued at US$656.9m due within 12 months. So its liabilities total US$3.28b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the US$2.06b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Cornerstone Building Brands would likely require a major re-capitalisation if it had to pay its creditors today.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While we wouldn’t worry about Cornerstone Building Brands’s net debt to EBITDA ratio of 3.9, we think its super-low interest cover of 1.7 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. However, one redeeming factor is that Cornerstone Building Brands grew its EBIT at 17% over the last 12 months, boosting its ability to handle its debt. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Cornerstone Building Brands’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 it’s worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Cornerstone Building Brands recorded free cash flow of 21% of its EBIT, which is weaker than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

On the face of it, Cornerstone Building Brands’s interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it’s pretty decent at growing its EBIT; that’s encouraging. Overall, it seems to us that Cornerstone Building Brands’s balance sheet is really quite a risk to the business. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it.