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.' 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. Importantly, Peet Limited (ASX:PPC) does carry debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. 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. 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 Peet
How Much Debt Does Peet Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2020 Peet had AU$292.9m of debt, an increase on AU$257.1m, over one year. On the flip side, it has AU$46.8m in cash leading to net debt of about AU$246.1m.
How Healthy Is Peet's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Peet had liabilities of AU$174.6m due within 12 months and liabilities of AU$201.4m due beyond that. Offsetting this, it had AU$46.8m in cash and AU$45.5m in receivables that were due within 12 months. So its liabilities total AU$283.7m more than the combination of its cash and short-term receivables.
Peet has a market capitalization of AU$507.5m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).
With a net debt to EBITDA ratio of 11.7, it's fair to say Peet does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 3.8 times, suggesting it can responsibly service its obligations. Worse, Peet's EBIT was down 67% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Peet'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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Peet recorded free cash flow of 30% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Our View
To be frank both Peet's net debt to EBITDA and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least its level of total liabilities is not so bad. Overall, it seems to us that Peet'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. 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. Take risks, for example - Peet has 2 warning signs we think you should be aware of.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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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. 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.
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About ASX:PPC
Second-rate dividend payer low.
