Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ 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. Importantly, GP Strategies Corporation (NYSE:GPX) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.

What Is GP Strategies’s Debt?

You can click the graphic below for the historical numbers, but it shows that GP Strategies had US$12.7m of debt in December 2020, down from US$86.6m, one year before. However, its balance sheet shows it holds US$23.1m in cash, so it actually has US$10.3m net cash.

How Strong Is GP Strategies’ Balance Sheet?

Zooming in on the latest balance sheet data, we can see that GP Strategies had liabilities of US$119.5m due within 12 months and liabilities of US$39.0m due beyond that. Offsetting these obligations, it had cash of US$23.1m as well as receivables valued at US$138.7m due within 12 months. So it actually has US$3.32m more liquid assets than total liabilities.

This state of affairs indicates that GP Strategies’ balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it’s very unlikely that the US$282.8m company is short on cash, but still worth keeping an eye on the balance sheet. Simply put, the fact that GP Strategies has more cash than debt is arguably a good indication that it can manage its debt safely.

Shareholders should be aware that GP Strategies’s EBIT was down 21% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if GP Strategies can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. While GP Strategies has net cash on its balance sheet, it’s still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Happily for any shareholders, GP Strategies actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing up

While it is always sensible to investigate a company’s debt, in this case GP Strategies has US$10.3m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of US$57m, being 126% of its EBIT. So we don’t have any problem with GP Strategies’s use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it.