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 Gates Industrial Corporation plc (NYSE:GTES) does use debt in its business. But is this debt a concern to shareholders?
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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Gates Industrial Carry?
As you can see below, Gates Industrial had US$3.02b of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. On the flip side, it has US$411.0m in cash leading to net debt of about US$2.60b.
How Strong Is Gates Industrial's Balance Sheet?
The latest balance sheet data shows that Gates Industrial had liabilities of US$641.3m due within a year, and liabilities of US$3.81b falling due after that. On the other hand, it had cash of US$411.0m and US$793.4m worth of receivables due within a year. So its liabilities total US$3.24b more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company's market capitalization of US$2.90b, we think shareholders really should watch Gates Industrial's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). 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).
Gates Industrial has a debt to EBITDA ratio of 3.9 and its EBIT covered its interest expense 3.0 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. More concerning, Gates Industrial saw its EBIT drop by 7.3% in the last twelve months. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Gates Industrial'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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Gates Industrial recorded free cash flow of 45% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
To be frank both Gates Industrial's interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. Having said that, its ability to convert EBIT to free cash flow isn't such a worry. Overall, it seems to us that Gates Industrial's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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