Is GUD Holdings (ASX:GUD) A Risky Investment?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. We can see that GUD Holdings Limited (ASX:GUD) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. 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. 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.

Our analysis indicates that GUD is potentially undervalued!

How Much Debt Does GUD Holdings Carry?

The image below, which you can click on for greater detail, shows that at June 2022 GUD Holdings had debt of AU$528.2m, up from AU$189.3m in one year. However, it does have AU$59.4m in cash offsetting this, leading to net debt of about AU$468.8m.

A Look At GUD Holdings' Liabilities

Zooming in on the latest balance sheet data, we can see that GUD Holdings had liabilities of AU$258.8m due within 12 months and liabilities of AU$776.7m due beyond that. Offsetting this, it had AU$59.4m in cash and AU$205.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$770.5m.

This is a mountain of leverage relative to its market capitalization of AU$1.08b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

GUD Holdings has net debt to EBITDA of 3.0 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 7.4 times its interest expense, and its net debt to EBITDA, was quite high, at 3.0. It is well worth noting that GUD Holdings's EBIT shot up like bamboo after rain, gaining 40% in the last twelve months. That'll make it easier 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 GUD Holdings 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, GUD Holdings recorded free cash flow worth 65% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

When it comes to the balance sheet, the standout positive for GUD Holdings was the fact that it seems able to grow its EBIT confidently. But the other factors we noted above weren't so encouraging. For example, its level of total liabilities makes us a little nervous about its debt. Considering this range of data points, we think GUD Holdings 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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 5 warning signs for GUD Holdings (of which 1 is significant!) you should know about.

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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.