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.’ 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. We note that Jacobs Engineering Group Inc. (NYSE:J) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 Jacobs Engineering Group’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of July 2021 Jacobs Engineering Group had US$3.14b of debt, an increase on US$2.18b, over one year. On the flip side, it has US$1.42b in cash leading to net debt of about US$1.72b.
How Strong Is Jacobs Engineering Group’s Balance Sheet?
The latest balance sheet data shows that Jacobs Engineering Group had liabilities of US$3.24b due within a year, and liabilities of US$5.18b falling due after that. On the other hand, it had cash of US$1.42b and US$3.19b worth of receivables due within a year. So it has liabilities totalling US$3.82b more than its cash and near-term receivables, combined.
This deficit isn’t so bad because Jacobs Engineering Group is worth a massive US$17.3b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Jacobs Engineering Group’s net debt is only 1.5 times its EBITDA. And its EBIT covers its interest expense a whopping 22.2 times over. So we’re pretty relaxed about its super-conservative use of debt. But the bad news is that Jacobs Engineering Group has seen its EBIT plunge 10% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. 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 Jacobs Engineering Group’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Jacobs Engineering Group’s free cash flow amounted to 33% of its EBIT, less than we’d expect. That’s not great, when it comes to paying down debt.
Our View
When it comes to the balance sheet, the standout positive for Jacobs Engineering Group was the fact that it seems able to cover its interest expense with its EBIT confidently. But the other factors we noted above weren’t so encouraging. For example, its EBIT growth rate makes us a little nervous about its debt. When we consider all the factors mentioned above, we do feel a bit cautious about Jacobs Engineering Group’s use of debt. While we appreciate debt can enhance returns on equity, we’d suggest that shareholders keep close watch on its debt levels, lest they increase. When analysing debt levels, the balance sheet is the obvious place to start.