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. 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 can see that McGrath RentCorp (NASDAQ:MGRC) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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 McGrath RentCorp’s Debt?
As you can see below, McGrath RentCorp had US$293.4m of debt, at December 2019, which is about the same as the year before. You can click the chart for greater detail. Net debt is about the same, since the it doesn’t have much cash.
A Look At McGrath RentCorp’s Liabilities
Zooming in on the latest balance sheet data, we can see that McGrath RentCorp had liabilities of US$102.6m due within 12 months and liabilities of US$573.3m due beyond that. Offsetting these obligations, it had cash of US$2.34m as well as receivables valued at US$128.1m due within 12 months. So it has liabilities totalling US$545.4m more than its cash and near-term receivables, combined.
McGrath RentCorp has a market capitalization of US$1.26b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution.
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).
McGrath RentCorp’s net debt to EBITDA ratio of about 1.9 suggests only moderate use of debt. And its commanding EBIT of 11.5 times its interest expense, implies the debt load is as light as a peacock feather. We note that McGrath RentCorp grew its EBIT by 20% in the last year, and that should make it easier to pay down debt, going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if McGrath RentCorp 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 business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, McGrath RentCorp recorded free cash flow of 42% of its EBIT, which is weaker than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
Both McGrath RentCorp’s ability to to cover its interest expense with its EBIT and its EBIT growth rate gave us comfort that it can handle its debt. On the other hand, its level of total liabilities makes us a little less comfortable about its debt. Considering this range of data points, we think McGrath RentCorp is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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 2 warning signs for McGrath RentCorp that you should be aware of.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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