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.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Graham Holdings Company (NYSE:GHC) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Graham Holdings’s Debt?
The chart below, which you can click on for greater detail, shows that Graham Holdings had US$540.6m in debt in June 2020; about the same as the year before. But it also has US$705.0m in cash to offset that, meaning it has US$164.4m net cash.
A Look At Graham Holdings’s Liabilities
We can see from the most recent balance sheet that Graham Holdings had liabilities of US$818.1m falling due within a year, and liabilities of US$1.63b due beyond that. Offsetting these obligations, it had cash of US$705.0m as well as receivables valued at US$489.1m due within 12 months. So it has liabilities totalling US$1.3b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Graham Holdings has a market capitalization of US$2.17b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt. While it does have liabilities worth noting, Graham Holdings also has more cash than debt, so we’re pretty confident it can manage its debt safely.
In fact Graham Holdings’s saving grace is its low debt levels, because its EBIT has tanked 26% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Graham Holdings’s earnings that will influence how the balance sheet holds up in the future. So if you’re keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Graham Holdings has net cash on its balance sheet, it’s still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the most recent three years, Graham Holdings recorded free cash flow worth 50% 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.
While Graham Holdings does have more liabilities than liquid assets, it also has net cash of US$164.4m. So although we see some areas for improvement, we’re not too worried about Graham Holdings’s balance sheet. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we’ve identified 1 warning sign for Graham Holdings that you should be aware of.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
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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. 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.
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