Pact Group Holdings (ASX:PGH) Has A Somewhat Strained Balance Sheet

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 note that Pact Group Holdings Ltd (ASX:PGH) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Pact Group Holdings

What Is Pact Group Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2022 Pact Group Holdings had AU$716.0m of debt, an increase on AU$680.1m, over one year. However, because it has a cash reserve of AU$82.7m, its net debt is less, at about AU$633.3m.

How Healthy Is Pact Group Holdings' Balance Sheet?

We can see from the most recent balance sheet that Pact Group Holdings had liabilities of AU$548.1m falling due within a year, and liabilities of AU$1.16b due beyond that. On the other hand, it had cash of AU$82.7m and AU$192.6m worth of receivables due within a year. So its liabilities total AU$1.43b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the AU$284.0m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Pact Group Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

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.

While Pact Group Holdings's debt to EBITDA ratio (3.1) suggests that it uses some debt, its interest cover is very weak, at 2.0, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. More concerning, Pact Group Holdings saw its EBIT drop by 3.7% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Pact Group Holdings'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Pact Group Holdings produced sturdy free cash flow equating to 68% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

To be frank both Pact Group Holdings's interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, it seems to us that Pact Group Holdings's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example - Pact Group Holdings has 1 warning sign we think you should be aware of.

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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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.