The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Global Payments Inc. (NYSE:GPN) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 Global Payments’s Net Debt?
The image below, which you can click on for greater detail, shows that at September 2019 Global Payments had debt of US$9.59b, up from US$5.5k in one year. However, because it has a cash reserve of US$2.13b, its net debt is less, at about US$7.46b.
How Healthy Is Global Payments’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Global Payments had liabilities of US$4.28b due within 12 months and liabilities of US$13.0b due beyond that. On the other hand, it had cash of US$2.13b and US$2.42b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$12.7b.
While this might seem like a lot, it is not so bad since Global Payments has a huge market capitalization of US$59.7b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Global Payments’s debt is 4.8 times its EBITDA, and its EBIT cover its interest expense 3.7 times over. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. On a lighter note, we note that Global Payments grew its EBIT by 26% in the last year. If it can maintain that kind of improvement, its debt load will begin to melt away like glaciers in a warming world. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Global Payments 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, a company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Global Payments actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Global Payments’s conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. But we must concede we find its net debt to EBITDA has the opposite effect. When we consider the range of factors above, it looks like Global Payments is pretty sensible with its use of 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. To that end, you should be aware of the 3 warning signs we’ve spotted with Global Payments .
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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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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