We Think GrainCorp (ASX:GNC) Is Taking Some Risk With Its Debt

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.' 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. As with many other companies GrainCorp Limited (ASX:GNC) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for GrainCorp

How Much Debt Does GrainCorp Carry?

As you can see below, at the end of March 2022, GrainCorp had AU$2.31b of debt, up from AU$1.53b a year ago. Click the image for more detail. However, it does have AU$311.0m in cash offsetting this, leading to net debt of about AU$2.00b.

How Strong Is GrainCorp's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that GrainCorp had liabilities of AU$3.25b due within 12 months and liabilities of AU$442.8m due beyond that. Offsetting this, it had AU$311.0m in cash and AU$1.03b in receivables that were due within 12 months. So it has liabilities totalling AU$2.35b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's AU$1.69b market capitalization, you might well be inclined to review the balance sheet intently. 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 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.

GrainCorp's net debt to EBITDA ratio of about 2.2 suggests only moderate use of debt. And its strong interest cover of 32.7 times, makes us even more comfortable. We also note that GrainCorp improved its EBIT from a last year's loss to a positive AU$837m. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if GrainCorp can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, GrainCorp reported free cash flow worth 2.0% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

To be frank both GrainCorp's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Overall, we think it's fair to say that GrainCorp has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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 2 of them make us uncomfortable.

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.