Stock Analysis

Gale Pacific (ASX:GAP) Seems To Use Debt Rather Sparingly

ASX:GAP
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Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Gale Pacific Limited (ASX:GAP) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

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What Is Gale Pacific's Debt?

As you can see below, Gale Pacific had AU$31.6m of debt at December 2020, down from AU$40.7m a year prior. On the flip side, it has AU$27.7m in cash leading to net debt of about AU$3.89m.

debt-equity-history-analysis
ASX:GAP Debt to Equity History June 14th 2021

A Look At Gale Pacific's Liabilities

The latest balance sheet data shows that Gale Pacific had liabilities of AU$53.1m due within a year, and liabilities of AU$38.7m falling due after that. Offsetting this, it had AU$27.7m in cash and AU$38.6m in receivables that were due within 12 months. So its liabilities total AU$25.5m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Gale Pacific is worth AU$101.9m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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

With net debt sitting at just 0.16 times EBITDA, Gale Pacific is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 9.3 times the interest expense over the last year. Better yet, Gale Pacific grew its EBIT by 130% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Gale Pacific's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Gale Pacific recorded free cash flow worth a fulsome 82% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

Happily, Gale Pacific's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And the good news does not stop there, as its EBIT growth rate also supports that impression! Considering this range of factors, it seems to us that Gale Pacific is quite prudent with its debt, and the risks seem well managed. So the balance sheet looks pretty healthy, to us. 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. We've identified 2 warning signs with Gale Pacific , and understanding them should be part of your investment process.

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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