The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. We note that The Gorman-Rupp Company (NYSE:GRC) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Gorman-Rupp's Net Debt?

The image below, which you can click on for greater detail, shows that Gorman-Rupp had debt of US$383.0m at the end of September 2024, a reduction from US$410.2m over a year. However, it does have US$39.7m in cash offsetting this, leading to net debt of about US$343.3m.

How Healthy Is Gorman-Rupp's Balance Sheet?

The latest balance sheet data shows that Gorman-Rupp had liabilities of US$100.5m due within a year, and liabilities of US$415.6m falling due after that. Offsetting this, it had US$39.7m in cash and US$88.4m in receivables that were due within 12 months. So its liabilities total US$388.1m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Gorman-Rupp is worth US$1.02b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Gorman-Rupp's debt to EBITDA ratio (2.9) suggests that it uses some debt, its interest cover is very weak, at 2.4, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. However, one redeeming factor is that Gorman-Rupp grew its EBIT at 16% over the last 12 months, boosting its ability to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Gorman-Rupp 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Gorman-Rupp recorded free cash flow worth 59% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Gorman-Rupp's interest cover was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that it has an adequate capacity to grow its EBIT. When we consider all the factors mentioned above, we do feel a bit cautious about Gorman-Rupp's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 1 warning sign with Gorman-Rupp , and understanding them should be part of your investment process.

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.