Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. Like many other companies GPT Infraprojects Limited (NSE:GPTINFRA) uses debt. But the more important question is: what risk does this debt create?
When is debt dangerous?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. In the worst case, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. When we think about a company’s use of debt, we first look at cash and debt together.
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What is GPT Infraprojects’ net debt?
As you can see below, GPT Infraprojects had ₹2.62 billion in debt, as of March 2022, which is about the same as the previous year. You can click on the graph for more details. Net debt is about the same, since she doesn’t have a lot of cash.
How strong is GPT Infraprojects’ balance sheet?
The latest balance sheet data shows that GPT Infraprojects had liabilities of ₹3.71 billion due within one year, and liabilities of ₹911.8 million falling due thereafter. In return, he had ₹33.1 million in cash and ₹3.55 billion in receivables due within 12 months. Thus, its liabilities total ₹1.04 billion more than the combination of its cash and short-term receivables.
This shortfall is not that bad as GPT Infraprojects is worth ₹3.35 billion and therefore could probably raise enough capital to shore up its balance sheet, should the need arise. However, it is always worth taking a close look at its ability to repay debt.
We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). Thus, we consider debt to earnings with and without amortization and depreciation expense.
While we are not concerned about GPT Infraprojects’ net debt to EBITDA ratio of 3.0, we believe its extremely low interest coverage of 2.1x is a sign of high leverage. It seems clear that the cost of borrowing money is having a negative impact on shareholder returns lately. More worryingly, GPT Infraprojects has seen its EBIT fall by 2.0% over the last twelve months. If this earnings trend continues, the company will face an uphill battle to pay off its debt. There is no doubt that we learn the most about debt from the balance sheet. But it is the results of GPT Infraprojects that will influence the balance sheet in the future. So, when considering debt, it is definitely worth looking at the earnings trend. Click here for an interactive preview.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Over the past three years, GPT Infraprojects has produced strong free cash flow equivalent to 71% 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
From what we’ve seen, GPT Infraprojects doesn’t find it easy, given its interest coverage, but the other factors we’ve considered give us cause for optimism. In particular, we are blown away by its conversion of EBIT to free cash flow. Looking at all this data, we feel a bit cautious about GPT Infraprojects’ debt levels. While we understand that debt can improve return on equity, we suggest shareholders keep a close eye on their level of debt, lest it increase. 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. We have identified 3 warning signs with GPT Infraprojects (at least 1 which is concerning), and understanding them should be part of your investment process.
Of course, if you’re the type of investor who prefers to buy stocks without the burden of debt, then feel free to check out our exclusive list of cash-efficient growth stocks today.
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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.
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