Legendary fund manager Li Lu (whom Charlie Munger supported) once said, âThe biggest risk in investing is not price volatility, but the fact that you suffer a permanent loss of capital. It’s only natural to consider a company’s balance sheet when looking at its level of risk, as debt is often involved when a business collapses. We note that Graphic packaging portfolio company (NYSE: GPK) has debt on its balance sheet. But the most important question is: what risk does this debt create?
When Is Debt a Problem?
Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. In the worst case scenario, a business can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that he must raise new equity at low cost, thereby diluting shareholders over the long term. Of course, debt can be an important tool in businesses, especially capital intensive businesses. The first thing to do when considering how much debt a business uses is to look at its cash flow and debt together.
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What is Graphic Packaging Holding’s net debt?
As you can see below, at the end of June 2021, Graphic Packaging Holding was in debt of $ 3.63 billion, up from $ 3.38 billion a year ago. Click on the image for more details. However, it has $ 89.0 million in cash offsetting that, leading to net debt of around $ 3.54 billion.
A look at the liabilities of Graphic Packaging Holding
We can see from the most recent balance sheet that Graphic Packaging Holding had liabilities of US $ 1.46 billion maturing within one year and liabilities of US $ 4.57 billion maturing within one year. of the. In return, he had $ 89.0 million in cash and $ 593.0 million in receivables due within 12 months. As a result, its liabilities exceed the sum of its cash and (short-term) receivables by $ 5.35 billion.
This shortfall is sizable compared to its market capitalization of US $ 6.06 billion, so he suggests shareholders keep an eye on Graphic Packaging Holding’s use of debt. This suggests that shareholders would be heavily diluted if the company needed to consolidate its balance sheet quickly.
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 profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt versus EBITDA) and the actual interest charges associated with this debt (with its coverage rate). interests).
Graphic Packaging Holding’s debt is 3.5 times its EBITDA and its EBIT covers its interest charges 4.4 times. This suggests that while debt levels are significant, we would stop calling them problematic. The good news is that Graphic Packaging Holding has increased its EBIT by 31% over the past twelve months. Like a mother’s loving embrace of a newborn, this type of growth builds resilience, putting the business in a stronger position to manage debt. The balance sheet is clearly the area you need to focus on when analyzing debt. But it is future profits, more than anything, that will determine Graphic Packaging Holding’s ability to maintain a healthy balance sheet going forward. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
Finally, a business needs free cash flow to repay its debts; accounting profits are not enough. We must therefore clearly check whether this EBIT generates a corresponding free cash flow. Over the past three years, Graphic Packaging Holding has reported free cash flow of 10% of its EBIT, which is really pretty low. This low level of cash conversion undermines its ability to manage and repay its debts.
Our point of view
Neither Graphic Packaging Holding’s ability to convert EBIT into free cash flow nor its level of total liabilities gave us confidence in its ability to take on more debt. But the good news is that he seems to be able to increase his EBIT with ease. Taking the above factors together, we believe that Graphic Packaging Holding’s debt presents certain risks to the business. So while this leverage increases returns on equity, we wouldn’t really want to see it increase from here. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks lie on the balance sheet – far from it. For example – Graphic Packaging Holding has 4 warning signs we think you should be aware.
At the end of the day, sometimes it’s easier to focus on businesses that don’t even need to go into debt. Readers can access a list of growth stocks with zero net debt 100% free, at present.
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 shares 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 material. Simply Wall St does not have any position in the mentioned stocks.
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