Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from synonymous with risk.” It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. We can see that McGrath RentCorp (NASDAQ:MGRC) uses debt in its business. But should shareholders worry about its use of debt?
When is debt dangerous?
Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. If things go really bad, lenders can take over the business. However, a more frequent (but still costly) event is when a company has to issue shares at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, many companies use debt to finance their growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.
See our latest analysis for McGrath RentCorp
How much debt does McGrath RentCorp have?
As you can see below, at the end of September 2021, McGrath RentCorp had $459.5 million in debt, up from $250.0 million a year ago. Click on the image for more details. Net debt is about the same, since she doesn’t have a lot of cash.
How healthy is McGrath RentCorp’s balance sheet?
We can see from the most recent balance sheet that McGrath RentCorp had liabilities of US$137.3 million due in one year, and liabilities of US$760.6 million beyond. As compensation for these obligations, it had cash of US$2.38 million and receivables valued at US$168.8 million due within 12 months. Thus, its liabilities total $726.7 million more than the combination of its cash and short-term receivables.
This shortfall is not that bad because McGrath RentCorp is worth $1.88 billion and therefore could probably raise enough capital to shore up its balance sheet, should the need arise. But it is clear that it is essential to examine closely whether it can manage its debt without dilution.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
McGrath RentCorp has a debt-to-EBITDA ratio of 3.2, which signals significant debt, but is still fairly reasonable for most types of businesses. However, its interest coverage of 14.3 is very high, suggesting that interest charges on debt are currently quite low. Unfortunately, McGrath RentCorp has seen its EBIT fall by 4.5% over the last twelve months. If this earnings trend continues, its leverage will become heavy like the heart of a polar bear looking at its only cub. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether McGrath RentCorp 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, a business needs free cash flow to pay off its debts; book profits are not enough. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Over the past three years, McGrath RentCorp has produced strong free cash flow equivalent to 69% of its EBIT, which is what we expected. This free cash flow puts the company in a good position to repay its debt, should it arise.
Our point of view
On the balance sheet, the most notable positive for McGrath RentCorp is the fact that it appears to be able to cover its interest charges with its EBIT with confidence. But the other factors we noted above weren’t so encouraging. For example, its net debt to EBITDA makes us a bit nervous about its debt. Given this range of data points, we believe McGrath RentCorp is in a good position to manage its debt levels. That said, the charge is heavy enough that we recommend that any shareholder keep a close eye on it. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks reside on the balance sheet, far from it. These risks can be difficult to spot. Every business has them, and we’ve spotted 1 warning sign for McGrath RentCorp you should know.
Of course, if you’re the type of investor who prefers to buy stocks without the burden of debt, then feel free to check out our exclusive list of cash-efficient growth stocks today.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.