Here's Why Gorman-Rupp (NYSE:GRC) Has A Meaningful Debt Burden

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. Importantly, The Gorman-Rupp Company (NYSE:GRC) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Gorman-Rupp

What Is Gorman-Rupp's Net Debt?

As you can see below, at the end of September 2022, Gorman-Rupp had US$428.6m of debt, up from none a year ago. Click the image for more detail. However, it also had US$10.3m in cash, and so its net debt is US$418.3m.

How Strong Is Gorman-Rupp's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Gorman-Rupp had liabilities of US$94.9m due within 12 months and liabilities of US$449.0m due beyond that. Offsetting this, it had US$10.3m in cash and US$91.3m in receivables that were due within 12 months. So it has liabilities totalling US$442.2m more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of US$724.9m, so it does suggest shareholders should keep an eye on Gorman-Rupp's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a net debt to EBITDA ratio of 7.9, it's fair to say Gorman-Rupp does have a significant amount of debt. However, its interest coverage of 3.6 is reasonably strong, which is a good sign. More concerning, Gorman-Rupp saw its EBIT drop by 4.6% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its debt. 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 Gorman-Rupp 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, 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. Over the most recent three years, Gorman-Rupp recorded free cash flow worth 77% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Gorman-Rupp's struggle handle its debt, based on its EBITDA, had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example its conversion of EBIT to free cash flow was refreshing. Looking at all the angles mentioned above, it does seem to us that Gorman-Rupp is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. We've identified 4 warning signs with Gorman-Rupp (at least 2 which are concerning) , and understanding them should be part of your investment process.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.