Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘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. As with many other companies Pro-Pac Packaging Limited (ASX:PPG) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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.
What Is Pro-Pac Packaging’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Pro-Pac Packaging had AU$104.7m of debt, an increase on AU$102, over one year. However, it also had AU$23.6m in cash, and so its net debt is AU$81.2m.
A Look At Pro-Pac Packaging’s Liabilities
Zooming in on the latest balance sheet data, we can see that Pro-Pac Packaging had liabilities of AU$103.8m due within 12 months and liabilities of AU$99.1m due beyond that. On the other hand, it had cash of AU$23.6m and AU$96.6m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$82.8m.
This deficit is considerable relative to its market capitalization of AU$93.3m, so it does suggest shareholders should keep an eye on Pro-Pac Packaging’s use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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.
Pro-Pac Packaging shareholders face the double whammy of a high net debt to EBITDA ratio (6.4), and fairly weak interest coverage, since EBIT is just 0.41 times the interest expense. The debt burden here is substantial. However, the silver lining was that Pro-Pac Packaging achieved a positive EBIT of AU$3.3m in the last twelve months, an improvement on the prior year’s loss. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Pro-Pac Packaging’s earnings that will influence how the balance sheet holds up in the future. 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 it’s worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Pro-Pac Packaging actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Neither Pro-Pac Packaging’s ability to cover its interest expense with its EBIT nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. Taking the abovementioned factors together we do think Pro-Pac Packaging’s debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. 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. Case in point: We’ve spotted 4 warning signs for Pro-Pac Packaging you should be aware of, and 2 of them make us uncomfortable.
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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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