Stock Analysis

Here's Why Gale Pacific (ASX:GAP) Has A Meaningful Debt Burden

ASX:GAP
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Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Gale Pacific Limited (ASX:GAP) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

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What Is Gale Pacific's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2023 Gale Pacific had AU$39.2m of debt, an increase on AU$33.9m, over one year. However, it also had AU$23.6m in cash, and so its net debt is AU$15.5m.

debt-equity-history-analysis
ASX:GAP Debt to Equity History October 4th 2023

How Strong Is Gale Pacific's Balance Sheet?

We can see from the most recent balance sheet that Gale Pacific had liabilities of AU$76.1m falling due within a year, and liabilities of AU$26.8m due beyond that. Offsetting these obligations, it had cash of AU$23.6m as well as receivables valued at AU$45.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$34.2m.

This deficit isn't so bad because Gale Pacific is worth AU$59.6m, 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Gale Pacific has a very low debt to EBITDA ratio of 1.1 so it is strange to see weak interest coverage, with last year's EBIT being only 2.5 times the interest expense. So one way or the other, it's clear the debt levels are not trivial. Shareholders should be aware that Gale Pacific's EBIT was down 31% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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, Gale Pacific recorded free cash flow worth 78% 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

Gale Pacific's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. In particular, its conversion of EBIT to free cash flow was re-invigorating. Taking the abovementioned factors together we do think Gale Pacific's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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 Gale Pacific (of which 1 is a bit unpleasant!) you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.