Legendary fund manager Li Lu (whom Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but the fact that you suffer a permanent loss of capital. When we think about how risky a business is, we always like to look at its use of debt because debt overload can lead to bankruptcy. We note that Griffon Company (NYSE: GFF) has debt on its balance sheet. But should shareholders be concerned about its use of debt?

What risk does debt entail?

Debts and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still costly) situation is where a company has to dilute its shareholders at a cheap share price just to get its debt under control. That said, the most common situation is where a business manages its debt reasonably well – and to its own advantage. When we look at debt levels, we first consider both liquidity and debt levels.

See our latest review for Griffon

What is Griffon’s debt?

The image below, which you can click for more details, shows Griffon owed $ 1.04 billion in debt at the end of June 2021, a reduction from $ 1.12 billion on a year. On the other hand, it has $ 224.2 million in cash, resulting in net debt of around $ 814.1 million.

A look at Griffon’s responsibilities

According to the latest published balance sheet, Griffon had liabilities of US $ 466.5 million due within 12 months and liabilities of US $ 1.30 billion due beyond 12 months. In return, he had $ 224.2 million in cash and $ 437.4 million in receivables due within 12 months. As a result, its liabilities exceed the sum of its cash and (short-term) receivables by US $ 1.10 billion.

This is a mountain of leverage compared to its market cap of US $ 1.39 billion. This suggests that shareholders would be heavily diluted if the company needed to consolidate its balance sheet quickly.

We measure a company’s debt load relative to its earning capacity by looking at its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT) covers its interest costs (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.

Griffon has a debt to EBITDA ratio of 3.0 and his EBIT has covered his interest expense 3.3 times. Overall, this implies that while we wouldn’t like to see debt levels rise, we believe it can handle its current leverage. On a lighter note, note that Griffon has increased its EBIT by 28% over the past year. If he manages to maintain this kind of improvement, his debt load will begin to melt like glaciers in a warming world. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether Griffon can strengthen its balance sheet over time. So, if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.

Finally, while the IRS may love accounting profits, lenders only accept hard cash. It is therefore worth checking to what extent this EBIT is supported by free cash flow. Over the past three years, Griffon’s free cash flow has been 37% of its EBIT, less than we expected. It’s not great when it comes to paying down debt.

Our point of view

Neither Griffon’s ability to cover its interest expense with its EBIT nor its total liability level gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story and suggests some resilience. We think Griffon’s debt makes him a bit risky, having considered the aforementioned data points together. Not all risks are bad, as they can increase stock returns if they are profitable, but this risk of leverage is worth keeping in mind. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks lie on the balance sheet – far from it. For example – Griffon has 1 warning sign we think you should be aware.

At the end of the day, it’s often best to focus on businesses with no net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St does not have any position in the mentioned stocks.

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