Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Genpact Limited (NYSE:G) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Genpact Carry?
As you can see below, at the end of December 2020, Genpact had US$1.59b of debt, up from US$1.44b a year ago. Click the image for more detail. On the flip side, it has US$689.2m in cash leading to net debt of about US$901.7m.
How Strong Is Genpact’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Genpact had liabilities of US$1.20b due within 12 months and liabilities of US$1.84b due beyond that. Offsetting these obligations, it had cash of US$689.2m as well as receivables valued at US$881.0m due within 12 months. So its liabilities total US$1.47b more than the combination of its cash and short-term receivables.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Genpact recorded free cash flow worth a fulsome 81% of its EBIT, which is stronger than we’d usually expect. That puts it in a very strong position to pay down debt.
Our View
Happily, Genpact’s impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And that’s just the beginning of the good news since its interest cover is also very heartening. Looking at the bigger picture, we think Genpact’s use of debt seems quite reasonable and we’re not concerned about it. After all, sensible leverage can boost returns on equity. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it.