Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Grainger plc (LON:GRI) does carry debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is Grainger's Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2021 Grainger had UK£1.36b of debt, an increase on UK£1.27b, over one year. However, it also had UK£257.6m in cash, and so its net debt is UK£1.10b.
A Look At Grainger's Liabilities
According to the last reported balance sheet, Grainger had liabilities of UK£101.7m due within 12 months, and liabilities of UK£1.39b due beyond 12 months. Offsetting these obligations, it had cash of UK£257.6m as well as receivables valued at UK£28.2m due within 12 months. So it has liabilities totalling UK£1.20b more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of UK£1.96b, so it does suggest shareholders should keep an eye on Grainger's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With a net debt to EBITDA ratio of 9.4, it's fair to say Grainger does have a significant amount of debt. However, its interest coverage of 4.9 is reasonably strong, which is a good sign. We saw Grainger grow its EBIT by 8.7% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off 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 Grainger'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. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Grainger 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.
Based on what we've seen Grainger is not finding it easy, given its net debt to EBITDA, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its conversion of EBIT to free cash flow. When we consider all the factors mentioned above, we do feel a bit cautious about Grainger's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. Case in point: We've spotted 3 warning signs for Grainger you should be aware of, and 1 of them makes us a bit uncomfortable.
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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