Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from synonymous with risk.” So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. We can see that CRH S.A. (LON:CRH) uses debt in its business. But the more important question is: what risk does this debt create?
What risk does debt carry?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. When we think about a company’s use of debt, we first look at cash and debt together.
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What is CRH’s debt?
The image below, which you can click on for more details, shows CRH had $9.98 billion in debt at the end of June 2022, a reduction from $10.8 billion year-over-year. However, since he has a cash reserve of $6.83 billion, his net debt is less, at around $3.16 billion.
How healthy is CRH’s balance sheet?
According to the last published balance sheet, CRH had liabilities of $9.28 billion maturing within 12 months and liabilities of $14.1 billion maturing beyond 12 months. In return, it had $6.83 billion in cash and $5.86 billion in receivables due within 12 months. Thus, its liabilities total $10.7 billion more than the combination of its cash and short-term receivables.
While that might sound like a lot, it’s not that bad since CRH has a huge market capitalization of US$25.0 billion, and so it could probably bolster its balance sheet by raising capital if needed. But we definitely want to keep our eyes peeled for indications that its debt is too risky.
In order to assess a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its earnings before interest and taxes (EBIT) divided by its expenses. interest (its interest coverage). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
With a net debt of only 0.58 times EBITDA, CRH is undoubtedly quite conservative. And this view is supported by strong interest coverage, with EBIT amounting to 8.7 times interest expense over the past year. On top of that, we are happy to report that CRH has increased its EBIT by 42%, reducing the specter of future debt repayments. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether CRH can strengthen its balance sheet over time. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
Finally, a company can only repay its debts with cold hard cash, not with book profits. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, CRH has recorded free cash flow representing 90% of its EBIT, which is higher than what we usually expect. This positions him well to pay off debt if desired.
Our point of view
Fortunately, the impressive conversion of EBIT into free cash flow by CRH means that it has the upper hand on its debt. And the good news does not stop there, since its EBIT growth rate also confirms this impression! Zooming out, CRH seems to be using debt quite sensibly; and that gets the green light from us. Although debt carries risks, when used wisely, it can also generate a higher return on equity. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist outside of the balance sheet. Be aware that CRH displays 1 warning sign in our investment analysis you should know…
In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.
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