David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.’ So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. We can see that Genuine Parts Company (NYSE:GPC) does use debt in its business. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Genuine Parts’s Debt?
As you can see below, Genuine Parts had US$3.32b of debt, at September 2023, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has US$654.6m in cash leading to net debt of about US$2.66b.
A Look At Genuine Parts’ Liabilities
We can see from the most recent balance sheet that Genuine Parts had liabilities of US$7.80b falling due within a year, and liabilities of US$5.02b due beyond that. Offsetting this, it had US$654.6m in cash and US$3.22b in receivables that were due within 12 months. So it has liabilities totalling US$8.95b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Genuine Parts has a huge market capitalization of US$19.3b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Genuine Parts’s net debt is only 1.3 times its EBITDA. And its EBIT covers its interest expense a whopping 26.2 times over. So we’re pretty relaxed about its super-conservative use of debt. On the other hand, Genuine Parts saw its EBIT drop by 4.5% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Genuine Parts can strengthen its balance sheet over time.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Genuine Parts recorded free cash flow worth 74% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Genuine Parts’s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. But truth be told we feel its EBIT growth rate does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that Genuine Parts can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it’s worth monitoring the balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt.