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Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ 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, Papoutsanis S.A. (ATH:PAP) does carry debt. But the more important question is: how much risk is that debt creating?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Papoutsanis Carry?
The image below, which you can click on for greater detail, shows that at December 2018 Papoutsanis had debt of €9.57m, up from €9.06m in one year. However, it also had €2.94m in cash, and so its net debt is €6.63m.
How Healthy Is Papoutsanis’s Balance Sheet?
According to the last reported balance sheet, Papoutsanis had liabilities of €9.29m due within 12 months, and liabilities of €11.7m due beyond 12 months. On the other hand, it had cash of €2.94m and €4.68m worth of receivables due within a year. So its liabilities total €13.4m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Papoutsanis has a market capitalization of €43.1m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. Either way, since Papoutsanis does have more debt than cash, it’s worth keeping an eye on its balance sheet.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Papoutsanis has a debt to EBITDA ratio of 2.61 and its EBIT covered its interest expense 2.86 times. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. The good news is that Papoutsanis grew its EBIT a smooth 69% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since Papoutsanis will need earnings to service that debt. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Papoutsanis reported free cash flow worth 6.9% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
When it comes to the balance sheet, the standout positive for Papoutsanis was the fact that it seems able to grow its EBIT confidently. However, our other observations weren’t so heartening. For example, its conversion of EBIT to free cash flow makes us a little nervous about its debt. When we consider all the factors mentioned above, we do feel a bit cautious about Papoutsanis’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. Over time, share prices tend to follow earnings per share, so if you’re interested in Papoutsanis, you may well want to click here to check an interactive graph of its earnings per share history.
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.
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If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.