David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, The Gap, Inc. (NYSE:GAP) does carry debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 Gap's Debt?
As you can see below, Gap had US$1.49b of debt, at November 2024, which is about the same as the year before. You can click the chart for greater detail. But on the other hand it also has US$2.22b in cash, leading to a US$730.0m net cash position.
A Look At Gap's Liabilities
According to the last reported balance sheet, Gap had liabilities of US$3.33b due within 12 months, and liabilities of US$5.39b due beyond 12 months. Offsetting these obligations, it had cash of US$2.22b as well as receivables valued at US$289.0m due within 12 months. So it has liabilities totalling US$6.21b more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of US$9.36b, so it does suggest shareholders should keep an eye on Gap's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. Despite its noteworthy liabilities, Gap boasts net cash, so it's fair to say it does not have a heavy debt load!
Even more impressive was the fact that Gap grew its EBIT by 177% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. The balance sheet is clearly the area to focus on when you are analysing debt. But it is 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 report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Gap has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Happily for any shareholders, Gap actually produced more free cash flow than EBIT over the last two years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Summing Up
While Gap does have more liabilities than liquid assets, it also has net cash of US$730.0m. The cherry on top was that in converted 149% of that EBIT to free cash flow, bringing in US$1.1b. So is Gap's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 1 warning sign we've spotted with Gap .
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.
