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.' 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 GECI International S.A. (EPA:GECP) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is GECI International's Debt?
The chart below, which you can click on for greater detail, shows that GECI International had €14.2m in debt in March 2019; about the same as the year before. However, it does have €3.99m in cash offsetting this, leading to net debt of about €10.2m.
How Strong Is GECI International's Balance Sheet?
According to the last reported balance sheet, GECI International had liabilities of €24.1m due within 12 months, and liabilities of €11.0m due beyond 12 months. Offsetting these obligations, it had cash of €3.99m as well as receivables valued at €18.1m due within 12 months. So its liabilities total €13.0m more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company's market capitalization of €11.3m, we think shareholders really should watch GECI International'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.
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). 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).
GECI International shareholders face the double whammy of a high net debt to EBITDA ratio (12.7), and fairly weak interest coverage, since EBIT is just 0.43 times the interest expense. This means we'd consider it to have a heavy debt load. However, the silver lining was that GECI International achieved a positive EBIT of €98k in the last twelve months, an improvement on the prior year's loss. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since GECI International will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, GECI International saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, GECI International's interest cover left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to grow its EBIT isn't such a worry. Taking into account all the aforementioned factors, it looks like GECI International has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. While GECI International didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away.Click here to see if its earnings are heading in the right direction, over the medium term.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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.