Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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 can see that Columbus McKinnon Corporation (NASDAQ:CMCO) does use debt in its business. But the real question is whether this debt is making the company risky.
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. 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. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Columbus McKinnon’s Debt?
As you can see below, at the end of June 2021, Columbus McKinnon had US$461.9m of debt, up from US$286.7m a year ago. Click the image for more detail. On the flip side, it has US$88.7m in cash leading to net debt of about US$373.3m.
A Look At Columbus McKinnon’s Liabilities
Zooming in on the latest balance sheet data, we can see that Columbus McKinnon had liabilities of US$245.2m due within 12 months and liabilities of US$611.0m due beyond that. Offsetting these obligations, it had cash of US$88.7m as well as receivables valued at US$127.0m due within 12 months. So its liabilities total US$640.6m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Columbus McKinnon has a market capitalization of US$1.40b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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).
Columbus McKinnon has a debt to EBITDA ratio of 4.7 and its EBIT covered its interest expense 3.9 times. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. Worse, Columbus McKinnon’s EBIT was down 24% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Columbus McKinnon 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 business needs free cash flow to pay off debt; accounting profits just don’t cut it. So it’s worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Columbus McKinnon actually produced more free cash flow than EBIT over the last three years. There’s nothing better than incoming cash when it comes to staying in your lenders’ good graces.
Our View
Neither Columbus McKinnon’s ability to grow its EBIT nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. Taking the abovementioned factors together we do think Columbus McKinnon’s debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt.