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 risk.” So it seems like smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess the level of risk of a business. Like many other companies Gates Industrial Corporation plc (NYSE: GTES) uses debt. But does this debt worry shareholders?
When is Debt a Problem?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it exists at their mercy. In the worst case scenario, a business can go bankrupt if it cannot pay its creditors. While it’s not too common, we often see indebted companies continually diluting their shareholders because lenders are forcing them to raise capital at a ridiculous price. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. When we think of a business’s use of debt, we first look at cash flow and debt together.
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What is the debt of Gates Industrial?
The image below, which you can click for more details, shows Gates Industrial owed US $ 2.62 billion in debt at the end of October 2021, a reduction from US $ 3.04 billion. over a year. However, he also had $ 540.6 million in cash, so his net debt is $ 2.08 billion.
A look at the liabilities of Gates Industrial
The latest balance sheet data shows Gates Industrial had liabilities of US $ 842.4 million due within one year, and liabilities of US $ 3.26 billion due thereafter. On the other hand, he had $ 540.6 million in cash and $ 848.7 million in receivables due within one year. Its liabilities therefore total $ 2.72 billion more than the combination of its cash and short-term receivables.
This is a mountain of leverage compared to its market cap of US $ 4.50 billion. If its lenders asked it to consolidate the balance sheet, shareholders would likely face severe dilution.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its earnings before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Gates Industrial’s debt is 2.8 times its EBITDA, and its EBIT covers its interest expense 3.6 times. This suggests that while debt levels are significant, we would stop calling them problematic. The silver lining is that Gates Industrial increased their EBIT by 106% last year, which nurtures like idealism among the youth. If this earnings trend continues, its debt load will be much more manageable in the future. There is no doubt that we learn the most about debt from the balance sheet. 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 Analyst Profit Forecast report interesting.
Finally, while the IRS may love accounting profits, lenders only accept hard cash. It is therefore worth checking to what extent this EBIT is supported by free cash flow. Over the past three years, Gates Industrial has generated strong free cash flow equivalent to 68% of its EBIT, roughly what we expected. This hard cash allows him to reduce his debt whenever he wants.
Our point of view
When it comes to the balance sheet, the main positive for Gates Industrial was the fact that it appears to be able to increase its EBIT with confidence. However, our other observations were not so encouraging. For example, his interest coverage makes us a little nervous about his debt. Given this range of data points, we believe Gates Industrial is well positioned to manage its debt levels. But beware: we believe debt levels are high enough to warrant continued monitoring. When analyzing debt levels, the balance sheet is the obvious place to start. But at the end of the day, every business can contain risks that exist off the balance sheet. For example, we have identified 1 warning sign for Gates Industrial that you need to be aware of.
If you want to invest in companies that can generate profits without the burden of debt, check out this free list of growing companies that have net cash on the balance sheet.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.