GrainCorp (ASX:GNC) Has A Somewhat Strained Balance Sheet

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that GrainCorp Limited (ASX:GNC) does have debt on its balance sheet. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for GrainCorp

How Much Debt Does GrainCorp Carry?

The image below, which you can click on for greater detail, shows that GrainCorp had debt of AU$1.73b at the end of March 2023, a reduction from AU$2.31b over a year. However, it does have AU$319.3m in cash offsetting this, leading to net debt of about AU$1.41b.

How Healthy Is GrainCorp's Balance Sheet?

The latest balance sheet data shows that GrainCorp had liabilities of AU$2.41b due within a year, and liabilities of AU$390.4m falling due after that. On the other hand, it had cash of AU$319.3m and AU$808.7m worth of receivables due within a year. So its liabilities total AU$1.67b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of AU$1.64b, we think shareholders really should watch GrainCorp's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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.

With a debt to EBITDA ratio of 2.4, GrainCorp uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 9.7 times its interest expenses harmonizes with that theme. Shareholders should be aware that GrainCorp's EBIT was down 38% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine GrainCorp'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 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. Looking at the most recent two years, GrainCorp recorded free cash flow of 36% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Mulling over GrainCorp's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that GrainCorp's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example GrainCorp has 3 warning signs (and 1 which doesn't sit too well with us) we think you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.