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 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 Service Corporation International (NYSE:SCI) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

What Is Service Corporation International's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2023 Service Corporation International had debt of US$4.62b, up from US$4.26b in one year. However, it also had US$221.6m in cash, and so its net debt is US$4.40b.

How Healthy Is Service Corporation International's Balance Sheet?

The latest balance sheet data shows that Service Corporation International had liabilities of US$749.1m due within a year, and liabilities of US$14.1b falling due after that. Offsetting these obligations, it had cash of US$221.6m as well as receivables valued at US$220.1m due within 12 months. So its liabilities total US$14.4b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's huge US$10.9b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Service Corporation International has a debt to EBITDA ratio of 3.5 and its EBIT covered its interest expense 3.9 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Even more troubling is the fact that Service Corporation International actually let its EBIT decrease by 5.3% over the last year. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. 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 Service Corporation International's ability to maintain a healthy balance sheet going forward. 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, Service Corporation International recorded free cash flow worth 51% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Mulling over Service Corporation International's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. Having said that, its ability to convert EBIT to free cash flow isn't such a worry. Overall, we think it's fair to say that Service Corporation International has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Service Corporation International is showing 2 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

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.

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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.