Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk. 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 can see that Standrew S.A. (WSE:STD) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Standrew Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Standrew had zł3.35m of debt, an increase on zł3.17m, over one year. However, it also had zł637.0k in cash, and so its net debt is zł2.71m.
How Strong Is Standrew’s Balance Sheet?
According to the last reported balance sheet, Standrew had liabilities of zł9.84m due within 12 months, and liabilities of zł3.73m due beyond 12 months. Offsetting this, it had zł637.0k in cash and zł5.28m in receivables that were due within 12 months. So its liabilities total zł7.65m more than the combination of its cash and short-term receivables.
Since publicly traded Standrew shares are worth a total of zł40.4m, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While Standrew has a quite reasonable net debt to EBITDA multiple of 1.5, its interest cover seems weak, at 2.4. This does suggest the company is paying fairly high interest rates. In any case, it’s safe to say the company has meaningful debt. We saw Standrew grow its EBIT by 7.0% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can’t view debt in total isolation; since Standrew will need earnings to service that debt. So if you’re keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Standrew created free cash flow amounting to 8.7% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
While Standrew’s conversion of EBIT to free cash flow makes us cautious about it, its track record of covering its interest expense with its EBIT is no better. At least its net debt to EBITDA gives us reason to be optimistic. We think that Standrew’s debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. Over time, share prices tend to follow earnings per share, so if you’re interested in Standrew, you may well want to click here to check an interactive graph of its earnings per share history.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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