We Think Gulf & Pacific Equities (CVE:GUF) Is Taking Some Risk With Its Debt

By
Simply Wall St
Published
January 20, 2022
TSXV:GUF
Source: Shutterstock

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.' 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 can see that Gulf & Pacific Equities Corp. (CVE:GUF) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Gulf & Pacific Equities

What Is Gulf & Pacific Equities's Net Debt?

The chart below, which you can click on for greater detail, shows that Gulf & Pacific Equities had CA$21.3m in debt in September 2021; about the same as the year before. And it doesn't have much cash, so its net debt is about the same.

debt-equity-history-analysis
TSXV:GUF Debt to Equity History January 20th 2022

A Look At Gulf & Pacific Equities' Liabilities

Zooming in on the latest balance sheet data, we can see that Gulf & Pacific Equities had liabilities of CA$4.33m due within 12 months and liabilities of CA$20.7m due beyond that. Offsetting this, it had CA$101.2k in cash and CA$217.5k in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$24.7m.

The deficiency here weighs heavily on the CA$6.28m 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'd watch its balance sheet closely, without a doubt. At the end of the day, Gulf & Pacific Equities would probably need a major re-capitalization if its creditors were to demand repayment.

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.

Weak interest cover of 1.3 times and a disturbingly high net debt to EBITDA ratio of 14.5 hit our confidence in Gulf & Pacific Equities like a one-two punch to the gut. The debt burden here is substantial. Fortunately, Gulf & Pacific Equities grew its EBIT by 5.0% in the last year, slowly shrinking its debt relative to earnings. 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 when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Gulf & Pacific Equities actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

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, we think it's fair to say that Gulf & Pacific Equities 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. However, not all investment risk resides within the balance sheet - far from it. Be aware that Gulf & Pacific Equities is showing 4 warning signs in our investment analysis , and 2 of those are a bit concerning...

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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