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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Galliford Try plc (LON:GFRD) makes use of debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Galliford Try Carry?
The image below, which you can click on for greater detail, shows that Galliford Try had debt of UK£648.1m at the end of June 2019, a reduction from UK£815.1m over a year. However, it also had UK£591.2m in cash, and so its net debt is UK£56.9m.
How Strong Is Galliford Try's Balance Sheet?
The latest balance sheet data shows that Galliford Try had liabilities of UK£1.81b due within a year, and liabilities of UK£203.8m falling due after that. On the other hand, it had cash of UK£591.2m and UK£680.4m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£741.8m.
This is a mountain of leverage relative to its market capitalization of UK£775.1m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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).
Galliford Try's net debt is only 0.39 times its EBITDA. And its EBIT easily covers its interest expense, being 39.5 times the size. So we're pretty relaxed about its super-conservative use of debt. In fact Galliford Try's saving grace is its low debt levels, because its EBIT has tanked 21% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Galliford Try'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Galliford Try created free cash flow amounting to 13% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
Mulling over Galliford Try's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Galliford Try's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. Given our hesitation about the stock, it would be good to know if Galliford Try insiders have sold any shares recently. You click here to find out if insiders have sold 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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