Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, CGI Inc. (TSE:GIB.A) does carry debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. 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.
What Is CGI's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2020 CGI had CA$3.51b of debt, an increase on CA$2.14b, over one year. However, because it has a cash reserve of CA$1.68b, its net debt is less, at about CA$1.83b.
A Look At CGI's Liabilities
Zooming in on the latest balance sheet data, we can see that CGI had liabilities of CA$3.90b due within 12 months and liabilities of CA$4.20b due beyond that. Offsetting this, it had CA$1.68b in cash and CA$2.30b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$4.12b.
Given CGI has a humongous market capitalization of CA$24.0b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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.
CGI's net debt is only 0.87 times its EBITDA. And its EBIT easily covers its interest expense, being 18.2 times the size. So we're pretty relaxed about its super-conservative use of debt. CGI's EBIT was pretty flat over the last year, but that shouldn't be an issue given the it doesn't have a lot of debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine CGI'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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, CGI recorded free cash flow worth 78% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
The good news is that CGI's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Looking at the bigger picture, we think CGI's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for CGI you should know about.
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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CGI Inc., together with its subsidiaries, provides information technology (IT) and business process services in Canada; Western, Southern, Central, and Eastern Europe; Australia; Scandinavia; Finland, Poland, and Baltics; the United States; the United Kingdom; and the Asia Pacific.
Excellent balance sheet and fair value.