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 seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. We can see that Carel Industries S.p.A. (BIT:CRL) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Carel Industries Carry?
As you can see below, Carel Industries had €127.6m of debt at March 2021, down from €140.7m a year prior. On the flip side, it has €110.9m in cash leading to net debt of about €16.7m.
How Strong Is Carel Industries’ Balance Sheet?
The latest balance sheet data shows that Carel Industries had liabilities of €123.2m due within a year, and liabilities of €128.3m falling due after that. On the other hand, it had cash of €110.9m and €72.1m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €68.5m.
Of course, Carel Industries has a market capitalization of €2.13b, so these liabilities are probably manageable. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse. But either way, Carel Industries has virtually no net debt, so it’s fair to say it does not have a heavy debt load!
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). 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).
Carel Industries’s net debt is only 0.25 times its EBITDA. And its EBIT covers its interest expense a whopping 39.5 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also positive, Carel Industries grew its EBIT by 24% in the last year, and that should make it easier to pay down debt, going forward. 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 Carel Industries 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Carel Industries recorded free cash flow worth 58% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Happily, Carel Industries’s impressive interest cover implies it has the upper hand on its debt. And that’s just the beginning of the good news since its net debt to EBITDA is also very heartening. Zooming out, Carel Industries seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it. We’ve identified 2 warning signs with Carel Industries , and understanding them should be part of your investment process.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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