Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 GPT Infraprojects Limited (NSE:GPTINFRA) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is GPT Infraprojects's Debt?
You can click the graphic below for the historical numbers, but it shows that GPT Infraprojects had ₹2.28b of debt in September 2020, down from ₹2.49b, one year before. However, because it has a cash reserve of ₹510.6m, its net debt is less, at about ₹1.77b.
How Healthy Is GPT Infraprojects' Balance Sheet?
The latest balance sheet data shows that GPT Infraprojects had liabilities of ₹4.20b due within a year, and liabilities of ₹405.6m falling due after that. On the other hand, it had cash of ₹510.6m and ₹2.88b worth of receivables due within a year. So it has liabilities totalling ₹1.22b more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company's ₹1.14b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
While GPT Infraprojects has a quite reasonable net debt to EBITDA multiple of 2.4, its interest cover seems weak, at 1.7. This does suggest the company is paying fairly high interest rates. In any case, it's safe to say the company has meaningful debt. Notably GPT Infraprojects's EBIT was pretty flat over the last year. Ideally it can diminish its debt load by kick-starting earnings growth. The balance sheet is clearly the area to focus on when you are analysing debt. But it is GPT Infraprojects's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, GPT Infraprojects generated free cash flow amounting to a very robust 86% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
Neither GPT Infraprojects's ability to cover its interest expense with its EBIT nor its level of total liabilities gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think GPT Infraprojects's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. For instance, we've identified 4 warning signs for GPT Infraprojects (2 are potentially serious) you should be aware of.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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