We Think PolyNovo (ASX:PNV) Is Taking Some Risk With Its Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that PolyNovo Limited (ASX:PNV) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 PolyNovo

What Is PolyNovo's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2021 PolyNovo had debt of AU$8.63m, up from AU$7.43m in one year. However, it does have AU$3.34m in cash offsetting this, leading to net debt of about AU$5.29m.

How Strong Is PolyNovo's Balance Sheet?

The latest balance sheet data shows that PolyNovo had liabilities of AU$8.96m due within a year, and liabilities of AU$7.56m falling due after that. On the other hand, it had cash of AU$3.34m and AU$6.23m worth of receivables due within a year. So it has liabilities totalling AU$6.96m more than its cash and near-term receivables, combined.

This state of affairs indicates that PolyNovo's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the AU$615.4m company is short on cash, but still worth keeping an eye on the balance sheet. Carrying virtually no net debt, PolyNovo has a very light debt load indeed.

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.

PolyNovo has a debt to EBITDA ratio of 2.8 and its EBIT covered its interest expense 3.0 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. However, the silver lining was that PolyNovo achieved a positive EBIT of AU$905k in the last twelve months, an improvement on the prior year's loss. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine PolyNovo's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, PolyNovo burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

PolyNovo's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability to to handle its total liabilities isn't too shabby at all. It's also worth noting that PolyNovo is in the Medical Equipment industry, which is often considered to be quite defensive. Looking at all the angles mentioned above, it does seem to us that PolyNovo is a somewhat risky investment as a result of its debt. 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. For example - PolyNovo has 2 warning signs we think you should be aware of.

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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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.