Stock Analysis

GWA Group (ASX:GWA) Seems To Use Debt Quite Sensibly

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ASX:GWA
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Warren Buffett famously said, '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. We can see that GWA Group Limited (ASX:GWA) does use debt in its business. But is this debt a concern to shareholders?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

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What Is GWA Group's Net Debt?

As you can see below, GWA Group had AU$178.3m of debt, at June 2020, which is about the same as the year before. You can click the chart for greater detail. However, it also had AU$32.4m in cash, and so its net debt is AU$146.0m.

debt-equity-history-analysis
ASX:GWA Debt to Equity History December 18th 2020

How Healthy Is GWA Group's Balance Sheet?

We can see from the most recent balance sheet that GWA Group had liabilities of AU$98.2m falling due within a year, and liabilities of AU$323.5m due beyond that. Offsetting this, it had AU$32.4m in cash and AU$56.6m in receivables that were due within 12 months. So its liabilities total AU$332.7m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since GWA Group has a market capitalization of AU$882.4m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With a debt to EBITDA ratio of 1.9, GWA Group uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 8.4 times its interest expenses harmonizes with that theme. Sadly, GWA Group's EBIT actually dropped 9.6% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine GWA Group'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, GWA Group produced sturdy free cash flow equating to 62% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Both GWA Group's ability to to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. Having said that, its EBIT growth rate somewhat sensitizes us to potential future risks to the balance sheet. Looking at all this data makes us feel a little cautious about GWA Group's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Consider risks, for instance. Every company has them, and we've spotted 3 warning signs for GWA Group you should know about.

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.

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