Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital”. It is only natural to consider a company’s balance sheet when looking at its level of risk, as debt is often involved when a business collapses. We can see that GP Industries Limited (SGX: G20) uses debt in its business. But does this debt concern shareholders?
When is debt dangerous?
Debts and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that he must raise new equity at low cost, thereby diluting shareholders over the long term. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. When we look at debt levels, we first consider both liquidity and debt levels.
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What is the debt of GP Industries?
As you can see below, at the end of March 2021, GP Industries was in debt of S $ 561.4 million, up from S $ 531.2 million a year ago. Click on the image for more details. On the other hand, he has S $ 227.4 million in cash, resulting in net debt of around S $ 334.0 million.
A look at the responsibilities of GP Industries
Zooming in on the latest balance sheet data, we can see that GP Industries had liabilities of S $ 778.9 million due within 12 months and S $ 212.1 million liabilities beyond. In return, he had S $ 227.4 million in cash and S $ 285.3 million in receivables due within 12 months. Thus, its liabilities total S $ 478.3 million more than the combination of its cash and short-term receivables.
The lack here weighs heavily on the S $ 275.8million business itself, as if a child struggles under the weight of a huge backpack full of books, his gym equipment and a trumpet. So we would be watching its record closely, without a doubt. After all, GP Industries would likely need a major recapitalization if it were to pay its creditors today.
In order to measure a company’s debt relative to its profits, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its profit before interest and taxes (EBIT) divided by its interest. debtors (its interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
GP Industries has a debt to EBITDA ratio of 4.7 and its EBIT covered its interest expense 2.6 times. This suggests that while debt levels are significant, we would stop calling them problematic. Looking on the bright side, GP Industries has increased its EBIT by a silky 71% over the past year. Like the milk of human kindness, this type of growth increases resilience, making the business more capable of handling debt. There is no doubt that we learn the most about debt from the balance sheet. But you can’t look at debt in isolation; since GP Industries will need income to repay this debt. So, when considering debt, it is really worth looking at the profit trend. Click here for an interactive snapshot.
Finally, while the IRS may love accounting profits, lenders only accept hard cash. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, GP Industries has spent a lot of money. While this may be the result of spending on growth, it makes debt much riskier.
Our point of view
To be frank, GP Industries’ EBIT conversion to free cash flow and its track record of controlling its total liabilities makes us rather uncomfortable with its debt levels. But on the positive side, its EBIT growth rate is a good sign and makes us more optimistic. Overall, it seems to us that GP Industries’ balance sheet is really very risky for the company. We are therefore almost as wary of this stock as a hungry kitten falls into its owner’s fish pond: once bitten, twice shy, as they say. The balance sheet is clearly the area you need to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist off the balance sheet. We have identified 1 warning sign with GP Industries, and understanding them should be part of your investment process.
If you are interested in investing in companies that can generate profits without the burden of debt, check out this page free list of growing companies that have net cash on the balance sheet.
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