The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ 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, Generac Holdings Inc. (NYSE:GNRC) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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 Generac Holdings’s Net Debt?
As you can see below, at the end of March 2022, Generac Holdings had US$1.06b of debt, up from US$845.1m a year ago. Click the image for more detail. However, it also had US$206.0m in cash, and so its net debt is US$858.0m.
How Healthy Is Generac Holdings’ Balance Sheet?
According to the last reported balance sheet, Generac Holdings had liabilities of US$1.25b due within 12 months, and liabilities of US$1.52b due beyond 12 months. On the other hand, it had cash of US$206.0m and US$609.9m worth of receivables due within a year. So it has liabilities totalling US$1.96b more than its cash and near-term receivables, combined.
Of course, Generac Holdings has a titanic market capitalization of US$13.9b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Generac Holdings’s net debt is only 1.1 times its EBITDA. And its EBIT easily covers its interest expense, being 20.7 times the size. So we’re pretty relaxed about its super-conservative use of debt. And we also note warmly that Generac Holdings grew its EBIT by 16% last year, making its debt load easier to handle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Generac Holdings’s ability to maintain a healthy balance sheet going forward.
Finally, while the tax-man may adore accounting profits, lenders only accept 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, Generac Holdings recorded free cash flow worth 56% 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.
Our View
Happily, Generac Holdings’s impressive interest cover implies it has the upper hand on its debt. And that’s just the beginning of the good news since its EBIT growth rate is also very heartening. When we consider the range of factors above, it looks like Generac Holdings is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. The balance sheet is clearly the area to focus on when you are analysing debt.