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.’ 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. We note that Carpenter Technology Corporation (NYSE:CRS) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Carpenter Technology’s Debt?

As you can see below, Carpenter Technology had US$694.8m of debt, at September 2021, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of US$213.2m, its net debt is less, at about US$481.6m.

How Strong Is Carpenter Technology’s Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Carpenter Technology had liabilities of US$332.4m due within 12 months and liabilities of US$1.26b due beyond that. On the other hand, it had cash of US$213.2m and US$311.6m worth of receivables due within a year. So it has liabilities totalling US$1.07b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of US$1.43b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Carpenter Technology’s ability to maintain a healthy balance sheet going forward.

Over 12 months, Carpenter Technology made a loss at the EBIT level, and saw its revenue drop to US$1.5b, which is a fall of 23%. To be frank that doesn’t bode well.

Caveat Emptor

While Carpenter Technology’s falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Indeed, it lost US$99m at the EBIT level. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. We would feel better if it turned its trailing twelve month loss of US$198m into a profit. So we do think this stock is quite risky.