Here's Why GrainCorp (ASX:GNC) Can Manage Its Debt Responsibly

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 GrainCorp Limited (ASX:GNC) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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 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.

Check out our latest analysis for GrainCorp

What Is GrainCorp's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2021 GrainCorp had debt of AU$726.0m, up from AU$364.2m in one year. However, it does have AU$126.6m in cash offsetting this, leading to net debt of about AU$599.4m.

How Healthy Is GrainCorp's Balance Sheet?

According to the last reported balance sheet, GrainCorp had liabilities of AU$1.11b due within 12 months, and liabilities of AU$383.7m due beyond 12 months. Offsetting this, it had AU$126.6m in cash and AU$440.2m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$925.6m.

This deficit isn't so bad because GrainCorp is worth AU$1.88b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

GrainCorp's net debt is only 1.5 times its EBITDA. And its EBIT covers its interest expense a whopping 14.5 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. It was also good to see that despite losing money on the EBIT line last year, GrainCorp turned things around in the last 12 months, delivering and EBIT of AU$340m. When analysing debt levels, the balance sheet is the obvious place to start. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Looking at the most recent year, GrainCorp recorded free cash flow of 36% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

When it comes to the balance sheet, the standout positive for GrainCorp was the fact that it seems able to cover its interest expense with its EBIT confidently. But the other factors we noted above weren't so encouraging. For instance it seems like it has to struggle a bit to handle its total liabilities. When we consider all the factors mentioned above, we do feel a bit cautious about GrainCorp's use of debt. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for GrainCorp you should be aware of, and 1 of them shouldn't be ignored.

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.