Goodfellow (TSE:GDL) Has A Pretty Healthy 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.' 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. Importantly, Goodfellow Inc. (TSE:GDL) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Goodfellow

What Is Goodfellow's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Goodfellow had CA$23.9m of debt in August 2020, down from CA$56.6m, one year before. On the flip side, it has CA$1.88m in cash leading to net debt of about CA$22.0m.

How Strong Is Goodfellow's Balance Sheet?

According to the last reported balance sheet, Goodfellow had liabilities of CA$68.8m due within 12 months, and liabilities of CA$17.2m due beyond 12 months. Offsetting this, it had CA$1.88m in cash and CA$64.5m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$19.6m.

While this might seem like a lot, it is not so bad since Goodfellow has a market capitalization of CA$68.5m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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.

Goodfellow has net debt of just 1.3 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 8.1 times, which is more than adequate. Even more impressive was the fact that Goodfellow grew its EBIT by 100% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Goodfellow will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Goodfellow actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Happily, Goodfellow's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Looking at the bigger picture, we think Goodfellow's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. 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 2 warning signs for Goodfellow you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. 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.
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