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.' 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. Importantly, GCP Applied Technologies Inc. (NYSE:GCP) does carry debt. But should shareholders be worried about its use of debt?
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. If things get really bad, the lenders can take control of the business. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is GCP Applied Technologies's Debt?
The chart below, which you can click on for greater detail, shows that GCP Applied Technologies had US$350.0m in debt in September 2020; about the same as the year before. But it also has US$473.4m in cash to offset that, meaning it has US$123.4m net cash.
How Healthy Is GCP Applied Technologies' Balance Sheet?
Zooming in on the latest balance sheet data, we can see that GCP Applied Technologies had liabilities of US$230.0m due within 12 months and liabilities of US$532.7m due beyond that. Offsetting these obligations, it had cash of US$473.4m as well as receivables valued at US$200.9m due within 12 months. So it has liabilities totalling US$88.4m more than its cash and near-term receivables, combined.
Since publicly traded GCP Applied Technologies shares are worth a total of US$1.88b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, GCP Applied Technologies boasts net cash, so it's fair to say it does not have a heavy debt load!
The bad news is that GCP Applied Technologies saw its EBIT decline by 18% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. 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're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. GCP Applied Technologies may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, GCP Applied Technologies burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
While it is always sensible to look at a company's total liabilities, it is very reassuring that GCP Applied Technologies has US$123.4m in net cash. Despite the cash, we do find GCP Applied Technologies's conversion of EBIT to free cash flow concerning, so we're not particularly comfortable with the stock. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for GCP Applied Technologies that you should be aware of.
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.
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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.