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 can see that Griffon Corporation (NYSE:GFF) does use debt in its business. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Griffon Carry?
The chart below, which you can click on for greater detail, shows that Griffon had US$1.17b in debt in June 2019; about the same as the year before. On the flip side, it has US$60.9m in cash leading to net debt of about US$1.11b.
A Look At Griffon's Liabilities
According to the last reported balance sheet, Griffon had liabilities of US$367.2m due within 12 months, and liabilities of US$1.26b due beyond 12 months. Offsetting these obligations, it had cash of US$60.9m as well as receivables valued at US$413.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.15b.
This deficit casts a shadow over the US$744.6m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt At the end of the day, Griffon would probably need a major re-capitalization if its creditors were to demand repayment.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Griffon shareholders face the double whammy of a high net debt to EBITDA ratio (5.7), and fairly weak interest coverage, since EBIT is just 2.0 times the interest expense. The debt burden here is substantial. Looking on the bright side, Griffon boosted its EBIT by a silky 46% in the last year. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. 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 Griffon's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Griffon's free cash flow amounted to 23% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
To be frank both Griffon's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. We're quite clear that we consider Griffon to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. Given our hesitation about the stock, it would be good to know if Griffon insiders have sold any shares recently. You click here to find out if insiders have sold recently.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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