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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 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. Importantly, Graham Corporation (NYSE:GHM) does carry debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Graham Carry?
The chart below, which you can click on for greater detail, shows that Graham had US$146.0k in debt in March 2019; about the same as the year before. But it also has US$77.8m in cash to offset that, meaning it has US$77.6m net cash.
How Healthy Is Graham’s Balance Sheet?
We can see from the most recent balance sheet that Graham had liabilities of US$54.9m falling due within a year, and liabilities of US$2.42m due beyond that. On the other hand, it had cash of US$77.8m and US$26.2m worth of receivables due within a year. So it can boast US$46.6m more liquid assets than total liabilities.
It’s good to see that Graham has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Due to its strong net asset position, it is not likely to face issues with its lenders. Graham boasts net cash, so it’s fair to say it does not have a heavy debt load!
Even more impressive was the fact that Graham grew its EBIT by 271% over twelve months. That boost will make it even 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 Graham 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Graham has net cash on its balance sheet, it’s still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Graham actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us excited like the crowd when the beat drops at a Daft Punk concert.
While we empathize with investors who find debt concerning, you should keep in mind that Graham has net cash of US$78m, as well as more liquid assets than liabilities. The cherry on top was that in converted 187% of that EBIT to free cash flow, bringing in US$5.8m. When it comes to Graham’s debt, we sufficiently relaxed that our mind turns to the jacuzzi. We’d be very excited to see if Graham insiders have been snapping up shares. If you are too, then click on this link right now to take a (free) peek at our list of reported insider transactions.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.