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.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, General Electric Company (NYSE:GE) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is General Electric’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that General Electric had US$62.9b of debt in September 2021, down from US$79.5b, one year before. However, it also had US$20.8b in cash, and so its net debt is US$42.1b.
How Strong Is General Electric’s Balance Sheet?
We can see from the most recent balance sheet that General Electric had liabilities of US$57.7b falling due within a year, and liabilities of US$140.5b due beyond that. On the other hand, it had cash of US$20.8b and US$20.1b worth of receivables due within a year. So its liabilities total US$157.3b more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company’s massive market capitalization of US$105.6b, we think shareholders really should watch General Electric’s debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
General Electric has a rather high debt to EBITDA ratio of 5.8 which suggests a meaningful debt load. However, its interest coverage of 3.1 is reasonably strong, which is a good sign. Investors should also be troubled by the fact that General Electric saw its EBIT drop by 11% over the last twelve months. If that’s the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine General Electric’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 always check how much of that EBIT is translated into free cash flow. During the last three years, General Electric generated free cash flow amounting to a very robust 96% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.
To be frank both General Electric’s level of total liabilities and its track record of managing its debt, based on its EBITDA, make us rather uncomfortable with its debt levels. But at least it’s pretty decent at converting EBIT to free cash flow; that’s encouraging. We’re quite clear that we consider General Electric to be really rather risky, as a result of its balance sheet health. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity.