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. Importantly, Commercial Metals Company (NYSE:CMC) does carry debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Commercial Metals’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that Commercial Metals had US$982.6m of debt in February 2021, down from US$1.12b, one year before. However, it also had US$367.3m in cash, and so its net debt is US$615.2m.
How Strong Is Commercial Metals’ Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Commercial Metals had liabilities of US$674.1m due within 12 months and liabilities of US$1.38b due beyond that. On the other hand, it had cash of US$367.3m and US$895.6m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$791.6m.
Given Commercial Metals has a market capitalization of US$3.99b, 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.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Commercial Metals has net debt of just 1.1 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 7.5 times, which is more than adequate. But the bad news is that Commercial Metals has seen its EBIT plunge 18% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Commercial Metals can strengthen its balance sheet over time.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Commercial Metals reported free cash flow worth 7.9% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
Commercial Metals’s EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its net debt to EBITDA is relatively strong. Taking the abovementioned factors together we do think Commercial Metals’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. There’s no doubt that we learn most about debt from the balance sheet.