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 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 Gibraltar Industries, Inc. (NASDAQ:ROCK) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. 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.
How Much Debt Does Gibraltar Industries Carry?
The image below, which you can click on for greater detail, shows that at December 2022 Gibraltar Industries had debt of US$88.8m, up from US$23.8m in one year. However, it also had US$17.6m in cash, and so its net debt is US$71.2m.
A Look At Gibraltar Industries’ Liabilities
According to the last reported balance sheet, Gibraltar Industries had liabilities of US$215.3m due within 12 months, and liabilities of US$173.2m due beyond 12 months. On the other hand, it had cash of US$17.6m and US$217.2m worth of receivables due within a year. So it has liabilities totalling US$153.8m more than its cash and near-term receivables, combined.
Given Gibraltar Industries has a market capitalization of US$1.52b, it’s hard to believe these liabilities pose much threat. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Gibraltar Industries has a low net debt to EBITDA ratio of only 0.43. And its EBIT covers its interest expense a whopping 34.6 times over. So we’re pretty relaxed about its super-conservative use of debt. Also positive, Gibraltar Industries grew its EBIT by 23% in the last year, and that should make it easier to pay down debt, going forward. 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 Gibraltar Industries 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 it’s worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Gibraltar Industries recorded free cash flow of 45% of its EBIT, which is weaker than we’d expect. That’s not great, when it comes to paying down debt.
Our View
The good news is that Gibraltar Industries’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its net debt to EBITDA also supports that impression! Looking at the bigger picture, we think Gibraltar Industries’s use of debt seems quite reasonable and we’re not concerned about it. After all, sensible leverage can boost returns on equity.