Is Gulf & Pacific Equities (CVE:GUF) Using Too Much 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.' 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. As with many other companies Gulf & Pacific Equities Corp. (CVE:GUF) 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Gulf & Pacific Equities

What Is Gulf & Pacific Equities's Debt?

As you can see below, Gulf & Pacific Equities had CA$22.0m of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. Net debt is about the same, since the it doesn't have much cash.

How Strong Is Gulf & Pacific Equities' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Gulf & Pacific Equities had liabilities of CA$3.91m due within 12 months and liabilities of CA$21.8m due beyond that. Offsetting this, it had CA$184.5k in cash and CA$188.9k in receivables that were due within 12 months. So its liabilities total CA$25.4m more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the CA$3.62m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Gulf & Pacific Equities would probably need a major re-capitalization if its creditors were to demand repayment.

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.

Weak interest cover of 1.2 times and a disturbingly high net debt to EBITDA ratio of 15.7 hit our confidence in Gulf & Pacific Equities like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Another concern for investors might be that Gulf & Pacific Equities's EBIT fell 16% in the last year. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Gulf & Pacific Equities will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Gulf & Pacific Equities actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

On the face of it, Gulf & Pacific Equities's interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, it seems to us that Gulf & Pacific Equities's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. When analysing debt levels, the balance sheet is the obvious place to start. 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 3 warning signs for Gulf & Pacific Equities (of which 2 are potentially serious!) you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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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