David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.’ 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 CRA International, Inc. (NASDAQ:CRAI) does have debt on its balance sheet. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is CRA International’s Net Debt?
The image below, which you can click on for greater detail, shows that CRA International had debt of US$40.0m at the end of April 2021, a reduction from US$70.0m over a year. However, it also had US$31.6m in cash, and so its net debt is US$8.37m.
How Strong Is CRA International’s Balance Sheet?
We can see from the most recent balance sheet that CRA International had liabilities of US$183.1m falling due within a year, and liabilities of US$148.1m due beyond that. On the other hand, it had cash of US$31.6m and US$168.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$130.7m.
This deficit isn’t so bad because CRA International is worth US$653.4m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution. Carrying virtually no net debt, CRA International has a very light debt load indeed.
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).
CRA International has a low net debt to EBITDA ratio of only 0.15. And its EBIT covers its interest expense a whopping 39.3 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also good is that CRA International grew its EBIT at 18% over the last year, further increasing its ability to manage debt. 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 CRA International can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, CRA International produced sturdy free cash flow equating to 70% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Happily, CRA International’s impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its net debt to EBITDA also supports that impression! Looking at the bigger picture, we think CRA International’s use of debt seems quite reasonable and we’re not concerned about it. After all, sensible leverage can boost returns on equity. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it.