Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about. It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies GATX Corporation (NYSE:GATX) makes use of debt. But the more important question is: how much risk is that debt creating?
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. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.
What Is GATX’s Debt?
The image below, which you can click on for greater detail, shows that at September 2019 GATX had debt of US$4.68b, up from US$4.4k in one year. Net debt is about the same, since the it doesn’t have much cash.
How Strong Is GATX’s Balance Sheet?
According to the last reported balance sheet, GATX had liabilities of US$250.4m due within 12 months, and liabilities of US$6.05b due beyond 12 months. Offsetting these obligations, it had cash of US$51.0m as well as receivables valued at US$180.4m due within 12 months. So its liabilities total US$6.07b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the US$2.72b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, GATX would probably need a major re-capitalization if its creditors were to demand repayment.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
GATX shareholders face the double whammy of a high net debt to EBITDA ratio (7.0), and fairly weak interest coverage, since EBIT is just 1.7 times the interest expense. This means we’d consider it to have a heavy debt load. Even more troubling is the fact that GATX actually let its EBIT decrease by 7.2% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine GATX’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, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, GATX saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
To be frank both GATX’s conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And furthermore, its interest cover also fails to instill confidence. Considering all the factors previously mentioned, we think that GATX really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. 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. Consider for instance, the ever-present spectre of investment risk. We’ve identified 4 warning signs with GATX (at least 2 which are potentially serious) , and understanding them should be part of your investment process.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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