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. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that The Goldfield Corporation (NYSEMKT:GV) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Goldfield's Debt?
As you can see below, at the end of June 2019, Goldfield had US$36.0m of debt, up from US$19.6m a year ago. Click the image for more detail. However, it also had US$15.5m in cash, and so its net debt is US$20.5m.
How Healthy Is Goldfield's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Goldfield had liabilities of US$25.0m due within 12 months and liabilities of US$39.3m due beyond that. Offsetting this, it had US$15.5m in cash and US$39.2m in receivables that were due within 12 months. So it has liabilities totalling US$9.66m more than its cash and near-term receivables, combined.
Given Goldfield has a market capitalization of US$50.8m, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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).
While Goldfield's low debt to EBITDA ratio of 1.4 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.4 last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Importantly, Goldfield's EBIT fell a jaw-dropping 40% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Goldfield 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Goldfield burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both Goldfield's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at managing its debt, based on its EBITDA,; that's encouraging. Looking at the bigger picture, it seems clear to us that Goldfield'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. Over time, share prices tend to follow earnings per share, so if you're interested in Goldfield, you may well want to click here to check an interactive graph of its earnings per share history.
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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