Is McGrath RentCorp (NASDAQ:MGRC) A Risky Investment?

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. Importantly, McGrath RentCorp (NASDAQ:MGRC) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for McGrath RentCorp

What Is McGrath RentCorp's Net Debt?

As you can see below, at the end of June 2023, McGrath RentCorp had US$672.6m of debt, up from US$441.5m a year ago. Click the image for more detail. Net debt is about the same, since the it doesn't have much cash.

How Healthy Is McGrath RentCorp's Balance Sheet?

The latest balance sheet data shows that McGrath RentCorp had liabilities of US$219.6m due within a year, and liabilities of US$1.01b falling due after that. Offsetting these obligations, it had cash of US$2.21m as well as receivables valued at US$191.7m due within 12 months. So its liabilities total US$1.03b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because McGrath RentCorp is worth US$2.40b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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

McGrath RentCorp has a debt to EBITDA ratio of 3.6 and its EBIT covered its interest expense 6.3 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. We note that McGrath RentCorp grew its EBIT by 25% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if McGrath RentCorp can strengthen its balance sheet over time. 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. During the last three years, McGrath RentCorp produced sturdy free cash flow equating to 51% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

On our analysis McGrath RentCorp's EBIT growth rate should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For example, its net debt to EBITDA makes us a little nervous about its debt. When we consider all the elements mentioned above, it seems to us that McGrath RentCorp is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. To that end, you should be aware of the 3 warning signs we've spotted with McGrath RentCorp .

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.