Gap (NYSE: GPS) has a somewhat strained record

Legendary fund manager Li Lu (whom Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but the possibility that you will suffer a permanent loss of capital.” So it can be obvious that you need to consider debt, when you think about how risky a given stock is, because too much debt can sink a business. We can see that The Gap, Inc. (NYSE: GPS) uses debt in its business. But the real question is whether this debt makes the business risky.

When is Debt a Problem?

Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it exists at their mercy. In the worst case scenario, a business can go bankrupt if it cannot pay its creditors. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash flow and debt together.

How Much Debt Does Gap Have?

As you can see below, Gap had $ 1.48 billion in debt in October 2021, up from $ 2.21 billion the year before. However, it has $ 1.08 billion in cash offsetting that, leading to net debt of around $ 408.0 million.

NYSE: GPS Historical Debt to Equity December 25, 2021

A look at Gap’s liabilities

The latest balance sheet data shows Gap had $ 3.82 billion in liabilities due within one year, and $ 6.17 billion in liabilities due thereafter. In return, he had $ 1.08 billion in cash and $ 363.0 million in receivables due within 12 months. Its liabilities therefore total $ 8.55 billion more than the combination of its cash and short-term receivables.

When you consider that this shortfall exceeds the company’s US $ 6.45 billion market capitalization, you may well be inclined to take a close look at the balance sheet. Hypothetically, extremely high dilution would be required if the company were forced to repay its debts by raising capital at the current share price.

We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its earnings before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt versus EBITDA) and the actual interest charges associated with this debt (with its coverage rate). interests).

Looking at its net debt over EBITDA of 0.31 and interest coverage of 4.1 times, it seems to us that Gap is probably using debt in a fairly reasonable way. But the interest payments are certainly enough to make us think about how affordable his debt is. We also note that Gap improved its EBIT from a loss last year to a positive amount of US $ 833 million. The balance sheet is clearly the area to focus on when analyzing debt. But it’s future earnings, more than anything, that will determine Gap’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free Analyst Profit Forecast report interesting.

Finally, while the IRS may love accounting profits, lenders only accept hard cash. It is therefore important to check to what extent its earnings before interest and taxes (EBIT) are converted into actual free cash flow. Over the past year, Gap has recorded total negative free cash flow. Debt is typically more expensive and almost always riskier in the hands of a business with negative free cash flow. Shareholders should hope for improvement.

Our point of view

At first glance, Gap’s level of total liabilities left us hesitant about the stock, and his conversion from EBIT to free cash flow was no more appealing than the single empty restaurant on the busiest night of the year. year. But on the bright side, its net debt to EBITDA is a good sign and makes us more optimistic. Overall, it seems to us that Gap’s balance sheet is really very risky for the company. For this reason, we are fairly cautious about the stock, and we believe shareholders should keep a close eye on its liquidity. When analyzing debt levels, the balance sheet is the obvious place to start. However, not all investment risks lie on the balance sheet – far from it. Know that Gap is displayed 3 warning signs in our investment analysis , and 1 of them is a bit disturbing …

Of course, if you are the type of investor who prefers to buy stocks without going into debt, feel free to check out our exclusive list of cash net 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 using only 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 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 documents. Simply Wall St has no position in any of the stocks mentioned.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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