Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from synonymous with risk.” So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. Like many other companies Gates Industrial Corporation plc (NYSE: GTES) uses debt. But should shareholders worry about its use of debt?
What risk does debt carry?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. If things go really bad, lenders can take over the business. However, a more frequent (but still costly) event is when a company has to issue shares at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
Check out our latest analysis for Gates Industrial
What is Gates Industrial’s net debt?
As you can see below, Gates Industrial had $2.64 billion in debt as of April 2022, about the same as the year before. You can click on the graph for more details. However, he has $412.6 million in cash to offset this, resulting in a net debt of approximately $2.23 billion.
How healthy is Gates Industrial’s balance sheet?
We can see from the most recent balance sheet that Gates Industrial had liabilities of US$788.5 million due in one year, and liabilities of US$3.23 billion due beyond. As compensation for these obligations, it had cash of US$412.6 million and receivables valued at US$823.5 million due within 12 months. Thus, its liabilities total $2.79 billion more than the combination of its cash and short-term receivables.
This shortfall is sizable relative to its market capitalization of US$3.09 billion, so it suggests shareholders keep an eye on Gates Industrial’s use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet quickly.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
Gates Industrial has a debt to EBITDA ratio of 3.4 and its EBIT covered its interest expense 3.3 times. Taken together, this implies that, while we wouldn’t like to see debt levels increase, we think he can manage his current leverage. On the other hand, Gates Industrial increased its EBIT by 20% last year. If sustained, this growth should cause this debt to evaporate like scarce drinking water during an abnormally hot summer. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether Gates Industrial can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, while the taxman may love accounting profits, lenders only accept cash. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Gates Industrial has produced strong free cash flow equivalent to 68% of its EBIT, which is what we expected. This cold hard cash allows him to reduce his debt whenever he wants.
Our point of view
While Gates Industrial’s level of total liabilities gives us pause, its rate of EBIT growth and the conversion of EBIT to free cash flow suggest it can stay above leverage. Looking at all the angles discussed above, it does seem to us that Gates Industrial is a somewhat risky investment due to its leverage. Not all risk is bad, as it can boost stock returns if it pays off, but this leverage risk is worth keeping in mind. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist outside of the balance sheet. Example: we have identified 2 warning signs for Gates Industrial you should be aware of, and 1 of them is potentially serious.
In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeat present.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.