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 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. We can see that Granite Construction Incorporated (NYSE:GVA) does use debt in its business. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Granite Construction's Net Debt?
The image below, which you can click on for greater detail, shows that Granite Construction had debt of US$288.2m at the end of June 2022, a reduction from US$345.7m over a year. However, it does have US$407.1m in cash offsetting this, leading to net cash of US$118.8m.
How Strong Is Granite Construction's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Granite Construction had liabilities of US$994.2m due within 12 months and liabilities of US$379.9m due beyond that. On the other hand, it had cash of US$407.1m and US$717.5m worth of receivables due within a year. So it has liabilities totalling US$249.6m more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Granite Construction has a market capitalization of US$1.19b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt. Despite its noteworthy liabilities, Granite Construction boasts net cash, so it's fair to say it does not have a heavy debt load!
Importantly, Granite Construction's EBIT fell a jaw-dropping 43% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Granite Construction can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Granite Construction 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. Over the last two years, Granite Construction saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
Summing Up
Although Granite Construction's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$118.8m. Despite its cash we think that Granite Construction seems to struggle to grow its EBIT, so we are wary of the stock. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 3 warning signs we've spotted with Granite Construction (including 2 which can't be ignored) .
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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