David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. Importantly, General Electric Company (NYSE:GE) does carry debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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 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.
What Is General Electric's Debt?
The image below, which you can click on for greater detail, shows that General Electric had debt of US$105.8b at the end of June 2019, a reduction from US$115.6b over a year. However, it does have US$13.6b in cash offsetting this, leading to net debt of about US$92.2b.
How Strong Is General Electric's Balance Sheet?
We can see from the most recent balance sheet that General Electric had liabilities of US$52.1b falling due within a year, and liabilities of US$203.9b due beyond that. Offsetting these obligations, it had cash of US$13.6b as well as receivables valued at US$20.2b due within 12 months. So it has liabilities totalling US$222.2b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the US$72.0b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, General Electric would likely require a major re-capitalisation if it had to pay its creditors today.
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).
With a net debt to EBITDA ratio of 6.1, it's fair to say General Electric does have a significant amount of debt. However, its interest coverage of 4.4 is reasonably strong, which is a good sign. One redeeming factor for General Electric is that it turned last year's EBIT loss into a gain of US$7.6b, over the last twelve months. 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 General Electric 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, General Electric burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, General Electric's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities 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. After considering the datapoints discussed, we think General Electric has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. Given the risks around General Electric's use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
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.
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