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.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, TopBuild Corp. (NYSE:BLD) does carry debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. 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. 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.
How Much Debt Does TopBuild Carry?
The chart below, which you can click on for greater detail, shows that TopBuild had US$699.1m in debt in September 2021; about the same as the year before. On the flip side, it has US$327.9m in cash leading to net debt of about US$371.2m.
How Strong Is TopBuild’s Balance Sheet?
We can see from the most recent balance sheet that TopBuild had liabilities of US$584.8m falling due within a year, and liabilities of US$974.2m due beyond that. On the other hand, it had cash of US$327.9m and US$516.9m worth of receivables due within a year. So it has liabilities totalling US$714.1m more than its cash and near-term receivables, combined.
Given TopBuild has a market capitalization of US$8.57b, it’s hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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). 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).
TopBuild has a low net debt to EBITDA ratio of only 0.70. And its EBIT easily covers its interest expense, being 17.9 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In addition to that, we’re happy to report that TopBuild has boosted its EBIT by 41%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine TopBuild’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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, TopBuild recorded free cash flow worth a fulsome 81% of its EBIT, which is stronger than we’d usually expect. That puts it in a very strong position to pay down debt.
Happily, TopBuild’s impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! We think TopBuild is no more beholden to its lenders, than the birds are to birdwatchers. To our minds it has a healthy happy balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt.