Yahoo Finance Here's Why Gap (NYSE:GPS) Can Manage Its Debt Responsibly
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.' 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. We note that The Gap, Inc. (NYSE:GPS) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
See our latest analysis for Gap
How Much Debt Does Gap Carry?
The chart below, which you can click on for greater detail, shows that Gap had US$2.22b in debt in July 2021; about the same as the year before. But on the other hand it also has US$2.71b in cash, leading to a US$492.0m net cash position.
How Healthy Is Gap's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Gap had liabilities of US$3.65b due within 12 months and liabilities of US$7.09b due beyond that. Offsetting this, it had US$2.71b in cash and US$363.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$7.66b.
This is a mountain of leverage relative to its market capitalization of US$9.25b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. Despite its noteworthy liabilities, Gap boasts net cash, so it's fair to say it does not have a heavy debt load!
Notably, Gap made a loss at the EBIT level, last year, but improved that to positive EBIT of US$854m in the last twelve months. 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 Gap 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. 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. Over the most recent year, Gap recorded free cash flow worth 78% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Summing up
Although Gap'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$492.0m. And it impressed us with free cash flow of US$663m, being 78% of its EBIT. So we are not troubled with Gap's debt use. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Gap is showing 3 warning signs in our investment analysis , you should know about...
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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