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 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. We can see that General Motors Company (NYSE:GM) does use debt in its business. 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. If things get really bad, the lenders can take control of the business. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does General Motors Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2020 General Motors had US$126.8b of debt, an increase on US$106.6b, over one year. On the flip side, it has US$31.0b in cash leading to net debt of about US$95.9b.
How Strong Is General Motors's Balance Sheet?
According to the last reported balance sheet, General Motors had liabilities of US$77.9b due within 12 months, and liabilities of US$116.1b due beyond 12 months. Offsetting this, it had US$31.0b in cash and US$7.95b in receivables that were due within 12 months. So it has liabilities totalling US$155.1b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the US$47.9b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, General Motors would likely require a major re-capitalisation if it had to pay its creditors today.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With a net debt to EBITDA ratio of 11.5, it's fair to say General Motors does have a significant amount of debt. However, its interest coverage of 5.7 is reasonably strong, which is a good sign. Importantly, General Motors's EBIT fell a jaw-dropping 62% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if General Motors can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
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. During the last three years, General Motors burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
To be frank both General Motors's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. Having said that, its ability to cover its interest expense with its EBIT isn't such a worry. Considering all the factors previously mentioned, we think that General Motors really is carrying too much debt. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 4 warning signs for General Motors (1 shouldn't be ignored) 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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