These 4 Measures Indicate That Grafton Group (LON:GFTU) Is Using Debt Reasonably Well

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 Grafton Group plc (LON:GFTU) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Grafton Group

What Is Grafton Group's Net Debt?

The image below, which you can click on for greater detail, shows that Grafton Group had debt of UK£201.7m at the end of June 2023, a reduction from UK£262.2m over a year. However, it does have UK£640.1m in cash offsetting this, leading to net cash of UK£438.4m.

How Healthy Is Grafton Group's Balance Sheet?

We can see from the most recent balance sheet that Grafton Group had liabilities of UK£564.0m falling due within a year, and liabilities of UK£661.0m due beyond that. Offsetting these obligations, it had cash of UK£640.1m as well as receivables valued at UK£293.2m due within 12 months. So it has liabilities totalling UK£291.6m more than its cash and near-term receivables, combined.

Since publicly traded Grafton Group shares are worth a total of UK£1.74b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Grafton Group also has more cash than debt, so we're pretty confident it can manage its debt safely.

On the other hand, Grafton Group's EBIT dived 12%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Grafton Group'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Grafton Group has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Grafton Group recorded free cash flow worth a fulsome 97% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Summing Up

While Grafton Group does have more liabilities than liquid assets, it also has net cash of UK£438.4m. And it impressed us with free cash flow of UK£211m, being 97% of its EBIT. So we are not troubled with Grafton Group's debt use. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for Grafton Group you should be aware of.

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. 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.