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. 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 note that GUD Holdings Limited (ASX:GUD) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
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. If things get really bad, the lenders can take control of the business. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
Check out our latest analysis for GUD Holdings
How Much Debt Does GUD Holdings Carry?
The image below, which you can click on for greater detail, shows that at June 2019 GUD Holdings had debt of AU$163.0m, up from AU$144.1m in one year. However, it also had AU$28.9m in cash, and so its net debt is AU$134.2m.
A Look At GUD Holdings's Liabilities
Zooming in on the latest balance sheet data, we can see that GUD Holdings had liabilities of AU$86.2m due within 12 months and liabilities of AU$161.4m due beyond that. Offsetting these obligations, it had cash of AU$28.9m as well as receivables valued at AU$107.6m due within 12 months. So its liabilities total AU$111.1m more than the combination of its cash and short-term receivables.
Of course, GUD Holdings has a market capitalization of AU$963.3m, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
GUD Holdings has a low net debt to EBITDA ratio of only 1.5. And its EBIT covers its interest expense a whopping 11.9 times over. So we're pretty relaxed about its super-conservative use of debt. The good news is that GUD Holdings has increased its EBIT by 5.3% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine GUD Holdings's ability to maintain a healthy balance sheet going forward. 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. Over the most recent three years, GUD Holdings recorded free cash flow worth 54% 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.
Our View
The good news is that GUD Holdings's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And we also thought its conversion of EBIT to free cash flow was a positive. All these things considered, it appears that GUD Holdings can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that GUD Holdings insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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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