Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Caterpillar Inc. (NYSE:CAT) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
Check out our latest analysis for Caterpillar
What Is Caterpillar's Net Debt?
The chart below, which you can click on for greater detail, shows that Caterpillar had US$36.5b in debt in September 2022; about the same as the year before. However, it does have US$7.42b in cash offsetting this, leading to net debt of about US$29.1b.
NYSE:CAT Debt to Equity History January 26th 2023
How Strong Is Caterpillar's Balance Sheet?
According to the last reported balance sheet, Caterpillar had liabilities of US$30.2b due within 12 months, and liabilities of US$35.1b due beyond 12 months. Offsetting this, it had US$7.42b in cash and US$7.51b in receivables that were due within 12 months. So its liabilities total US$50.4b more than the combination of its cash and short-term receivables.
Caterpillar has a very large market capitalization of US$134.5b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Caterpillar has a debt to EBITDA ratio of 2.6, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 27.7 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. We note that Caterpillar grew its EBIT by 30% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Caterpillar can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Caterpillar recorded free cash flow worth 65% 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.
Our View
Happily, Caterpillar's impressive interest cover implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its net debt to EBITDA. Taking all this data into account, it seems to us that Caterpillar takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Caterpillar you should be aware of, and 1 of them is potentially serious.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
Have feedback on this article? Concerned about the content?Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com. This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
