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.' 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. Importantly, Etropal AD (BUL:5EO) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is Etropal AD's Debt?
You can click the graphic below for the historical numbers, but it shows that Etropal AD had лв4.81m of debt in September 2020, down from лв5.07m, one year before. Net debt is about the same, since the it doesn't have much cash.
A Look At Etropal AD's Liabilities
We can see from the most recent balance sheet that Etropal AD had liabilities of лв7.93m falling due within a year, and liabilities of лв362.0k due beyond that. On the other hand, it had cash of лв91.0k and лв3.00m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by лв5.20m.
Of course, Etropal AD has a market capitalization of лв28.3m, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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.
Weak interest cover of 1.3 times and a disturbingly high net debt to EBITDA ratio of 5.7 hit our confidence in Etropal AD like a one-two punch to the gut. The debt burden here is substantial. Even more troubling is the fact that Etropal AD actually let its EBIT decrease by 7.1% over the last year. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Etropal AD will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Etropal AD saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
On the face of it, Etropal AD's interest cover left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least its level of total liabilities is not so bad. It's also worth noting that Etropal AD is in the Medical Equipment industry, which is often considered to be quite defensive. Looking at the bigger picture, it seems clear to us that Etropal AD's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with Etropal AD (at least 1 which shouldn't be ignored) , and understanding them should be part of your investment process.
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.
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