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.’ 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. We can see that Graphic Packaging Holding Company (NYSE:GPK) does use debt in its business. But the more important question is: how much risk is that debt creating?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.
What Is Graphic Packaging Holding’s Debt?
As you can see below, Graphic Packaging Holding had US$2.92b of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, because it has a cash reserve of US$64.9m, its net debt is less, at about US$2.86b.
How Healthy Is Graphic Packaging Holding’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Graphic Packaging Holding had liabilities of US$1.09b due within 12 months and liabilities of US$3.86b due beyond that. Offsetting these obligations, it had cash of US$64.9m as well as receivables valued at US$639.9m due within 12 months. So its liabilities total US$4.25b more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company’s market capitalization of US$3.75b, we think shareholders really should watch Graphic Packaging Holding’s debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Graphic Packaging Holding has a debt to EBITDA ratio of 2.9 and its EBIT covered its interest expense 4.1 times. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. On a lighter note, we note that Graphic Packaging Holding grew its EBIT by 28% in the last year. If it can maintain that kind of improvement, its debt load will begin to melt away like glaciers in a warming world. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Graphic Packaging Holding’s ability to maintain a healthy balance sheet going forward. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Graphic Packaging Holding 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.
Mulling over Graphic Packaging Holding’s attempt at converting EBIT to free cash flow, we’re certainly not enthusiastic. But at least it’s pretty decent at growing its EBIT; that’s encouraging. Looking at the bigger picture, it seems clear to us that Graphic Packaging Holding’s use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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.
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 email@example.com. 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.