These 4 Measures Indicate That GP Industries (SGX:G20) Is Using Debt In A Risky Way

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies GP Industries Limited (SGX:G20) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for GP Industries

What Is GP Industries's Net Debt?

As you can see below, GP Industries had S$485.6m of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of S$170.0m, its net debt is less, at about S$315.6m.

How Strong Is GP Industries' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that GP Industries had liabilities of S$758.1m due within 12 months and liabilities of S$83.5m due beyond that. Offsetting these obligations, it had cash of S$170.0m as well as receivables valued at S$268.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by S$402.9m.

The deficiency here weighs heavily on the S$261.4m 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 definitely think shareholders need to watch this one closely. After all, GP Industries would likely require a major re-capitalisation if it had to pay its creditors today.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 1.5 times and a disturbingly high net debt to EBITDA ratio of 5.6 hit our confidence in GP Industries like a one-two punch to the gut. The debt burden here is substantial. Worse, GP Industries's EBIT was down 30% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But it is GP Industries'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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, GP Industries burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both GP Industries's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And even its interest cover fails to inspire much confidence. It looks to us like GP Industries carries a significant balance sheet burden. If you play with fire you risk getting burnt, so we'd probably give this stock a wide berth. 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. For instance, we've identified 2 warning signs for GP Industries that 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. 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.
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