Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘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. As with many other companies Graco Inc. (NYSE:GGG) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Graco Carry?
As you can see below, Graco had US$163.1m of debt at June 2021, down from US$420.6m a year prior. But it also has US$482.8m in cash to offset that, meaning it has US$319.7m net cash.
How Strong Is Graco’s Balance Sheet?
The latest balance sheet data shows that Graco had liabilities of US$358.7m due within a year, and liabilities of US$389.2m falling due after that. On the other hand, it had cash of US$482.8m and US$354.2m worth of receivables due within a year. So it can boast US$89.1m more liquid assets than total liabilities.
This state of affairs indicates that Graco’s 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$13.1b company is short on cash, but still worth keeping an eye on the balance sheet. Simply put, the fact that Graco has more cash than debt is arguably a good indication that it can manage its debt safely.
In addition to that, we’re happy to report that Graco has boosted its EBIT by 39%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Graco’s ability to maintain a healthy balance sheet going forward.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Graco may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Graco produced sturdy free cash flow equating to 73% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
Summing up
While we empathize with investors who find debt concerning, you should keep in mind that Graco has net cash of US$319.7m, as well as more liquid assets than liabilities. And we liked the look of last year’s 39% year-on-year EBIT growth. So is Graco’s debt a risk? It doesn’t seem so to us. We’d be very excited to see if Graco insiders have been snapping up shares.