We Think Palfinger (VIE:PAL) Is Taking Some Risk With Its Debt

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Palfinger AG (VIE:PAL) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Palfinger

How Much Debt Does Palfinger Carry?

The image below, which you can click on for greater detail, shows that at December 2022 Palfinger had debt of €642.8m, up from €496.4m in one year. On the flip side, it has €61.1m in cash leading to net debt of about €581.7m.

How Healthy Is Palfinger's Balance Sheet?

According to the last reported balance sheet, Palfinger had liabilities of €662.7m due within 12 months, and liabilities of €620.6m due beyond 12 months. On the other hand, it had cash of €61.1m and €418.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €803.3m.

This deficit is considerable relative to its market capitalization of €1.12b, so it does suggest shareholders should keep an eye on Palfinger's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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).

Palfinger's net debt is 3.1 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 11.0 is very high, suggesting that the interest expense on the debt is currently quite low. We note that Palfinger grew its EBIT by 21% in the last year, and that should make it easier to pay down debt, going forward. 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 Palfinger's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Palfinger created free cash flow amounting to 14% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Even if we have reservations about how easily Palfinger is capable of converting EBIT to free cash flow, its interest cover and EBIT growth rate make us think feel relatively unconcerned. We think that Palfinger'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. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Palfinger (of which 1 doesn't sit too well with us!) you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.