Legendary fund manager Li Lu (whom Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but the possibility that you will suffer a permanent loss of capital.” When we think about how risky a business is, we always like to look at its use of debt because debt overload can lead to bankruptcy. We can see that Caterpillar Inc. (NYSE: CAT) uses debt in its business. But the real question is whether this debt makes the business risky.
What risk does debt entail?
Generally speaking, debt only becomes a real problem when a company cannot repay it easily, either by raising capital or with its own cash flow. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. While it’s not too common, we often see indebted companies continually diluting their shareholders because lenders are forcing them to raise capital at a ridiculous price. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution of a business with the ability to reinvest at high rates of return. The first step in examining a business’s debt levels is to consider its cash flow and debt together.
What is Caterpillar’s net debt?
As you can see below, Caterpillar had $ 36.8 billion in debt, as of September 2021, which is roughly the same as the year before. You can click on the graph for more details. However, given that it has a cash reserve of US $ 8.55 billion, its net debt is less, at approximately US $ 28.2 billion.
NYSE: CAT History of Debt to Equity December 4, 2021
A look at Caterpillar’s responsibilities
Zooming in on the latest balance sheet data, we can see that Caterpillar had $ 26.0 billion in liabilities due within 12 months and $ 38.1 billion in liabilities due beyond. On the other hand, he had $ 8.55 billion in cash and $ 7.50 billion in receivables due within one year. As a result, its liabilities exceed the sum of its cash and (short-term) receivables by $ 48.0 billion.
Caterpillar has a very large market capitalization of US $ 107.0 billion, so it could most likely raise funds to improve its balance sheet, should the need arise. But we absolutely want to keep our eyes open for indications that its debt is too risky.
We measure a company’s indebtedness relative to its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating the ease with which its earnings before interest and taxes (EBIT ) covers its interests. costs (interest coverage). Thus, we look at debt versus earnings with and without amortization expenses.
Caterpillar has a debt to EBITDA ratio of 3.0, which signals significant debt, but is still reasonable enough for most types of businesses. However, its interest coverage of 16.6 is very high, suggesting that interest charges on debt are currently quite low. Importantly, Caterpillar has increased its EBIT by 35% over the past twelve months, and this growth will make it easier to process its debt. 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 Caterpillar can strengthen its balance sheet over time. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
Finally, a business can only pay off its debts with hard cash, not with book profits. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Caterpillar has recorded free cash flow of 68% of its EBIT, which is close to normal given that free cash flow excludes interest and taxes. This hard cash allows him to reduce his debt whenever he wants.
Our point of view
Fortunately, Caterpillar’s impressive interest coverage means it has the upper hand on its debt. But frankly, we think its net debt to EBITDA undermines that impression a bit. Considering all of this data, it seems to us that Caterpillar is taking a fairly reasonable approach to debt. This means that they are taking a bit more risk, in the hope of increasing shareholder returns. When analyzing debt levels, the balance sheet is the obvious place to start. However, not all investment risks lie on the balance sheet – far from it. For example – Caterpillar has 2 warning signs we think you should be aware.
At the end of the day, it’s often best to focus on businesses that don’t have net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.
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