Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 can see that EMCOR Group, Inc. (NYSE:EME) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. 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 examine debt levels, we first consider both cash and debt levels, together.
What Is EMCOR Group’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that EMCOR Group had US$267.0m of debt in June 2021, down from US$295.5m, one year before. But on the other hand it also has US$668.9m in cash, leading to a US$401.9m net cash position.
How Strong Is EMCOR Group’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that EMCOR Group had liabilities of US$2.14b due within 12 months and liabilities of US$898.9m due beyond that. Offsetting this, it had US$668.9m in cash and US$2.33b in receivables that were due within 12 months. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.
Having regard to EMCOR Group’s size, it seems that its liquid assets are well balanced with its total liabilities. So it’s very unlikely that the US$6.27b company is short on cash, but still worth keeping an eye on the balance sheet. Despite its noteworthy liabilities, EMCOR Group boasts net cash, so it’s fair to say it does not have a heavy debt load!
And we also note warmly that EMCOR Group grew its EBIT by 15% last year, making its debt load easier to handle. 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 EMCOR Group’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. EMCOR Group may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, EMCOR Group generated free cash flow amounting to a very robust 92% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.
While it is always sensible to look at a company’s total liabilities, it is very reassuring that EMCOR Group has US$401.9m in net cash. And it impressed us with free cash flow of US$484m, being 92% of its EBIT. So we don’t think EMCOR Group’s use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt.