Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk’. 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. Importantly, Griffon Corporation (NYSE:GFF) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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 examine debt levels, we first consider both cash and debt levels, together.
What Is Griffon’s Debt?
The image below, which you can click on for greater detail, shows that at September 2019 Griffon had debt of US$1.10b, up from US$1.1k in one year. On the flip side, it has US$75.1m in cash leading to net debt of about US$1.03b.
A Look At Griffon’s Liabilities
The latest balance sheet data shows that Griffon had liabilities of US$390.1m due within a year, and liabilities of US$1.21b falling due after that. On the other hand, it had cash of US$75.1m and US$369.6m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.15b.
When you consider that this deficiency exceeds the company’s US$1.02b 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.
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.
Weak interest cover of 2.0 times and a disturbingly high net debt to EBITDA ratio of 5.2 hit our confidence in Griffon like a one-two punch to the gut. The debt burden here is substantial. Looking on the bright side, Griffon boosted its EBIT by a silky 31% in the last year. Like a mother’s loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Griffon can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Griffon’s free cash flow amounted to 28% of its EBIT, less than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
To be frank both Griffon’s net debt to EBITDA and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. But at least it’s pretty decent at growing its EBIT; that’s encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Griffon stock a bit risky. Some people like that sort of risk, but we’re mindful of the potential pitfalls, so we’d probably prefer it carry less 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. Consider for instance, the ever-present spectre of investment risk. We’ve identified 1 warning sign with Griffon , 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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