Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies. GCP Applied Technologies Inc. (NYSE:GCP) makes use of debt. But should shareholders be worried about its use of debt?
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, 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.
How Much Debt Does GCP Applied Technologies Carry?
As you can see below, GCP Applied Technologies had US$356.6m of debt at March 2019, down from US$542.9m a year prior. However, it does have US$298.6m in cash offsetting this, leading to net debt of about US$58.0m.
How Healthy Is GCP Applied Technologies’s Balance Sheet?
We can see from the most recent balance sheet that GCP Applied Technologies had liabilities of US$244.1m falling due within a year, and liabilities of US$536.4m due beyond that. Offsetting these obligations, it had cash of US$298.6m as well as receivables valued at US$204.4m due within 12 months. So it has liabilities totalling US$277.5m more than its cash and near-term receivables, combined.
Of course, GCP Applied Technologies has a market capitalization of US$1.60b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Because it carries more debt than cash, we think it’s worth watching GCP Applied Technologies’s balance sheet over time.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Looking at its net debt to EBITDA of 0.40 and interest cover of 4.62 times, it seems to us that GCP Applied Technologies is probably using debt in a pretty reasonable way. So we’d recommend keeping a close eye on the impact financing costs are having on the business. Sadly, GCP Applied Technologies’s EBIT actually dropped 6.0% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. 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 GCP Applied Technologies 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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, GCP Applied Technologies saw substantial negative free cash flow, in total. 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.
GCP Applied Technologies’s struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example, its net debt to EBITDA is relatively strong. Taking the abovementioned factors together we do think GCP Applied Technologies’s debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. In light of our reservations about the company’s balance sheet, it seems sensible to check if insiders have been selling shares recently.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
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