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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 note that Pinnacle Renewable Energy Inc. (TSE:PL) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Pinnacle Renewable Energy’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 Pinnacle Renewable Energy had CA$341.1m of debt, an increase on CA$197.0m, over one year. However, it does have CA$8.51m in cash offsetting this, leading to net debt of about CA$332.6m.
How Strong Is Pinnacle Renewable Energy’s Balance Sheet?
The latest balance sheet data shows that Pinnacle Renewable Energy had liabilities of CA$74.9m due within a year, and liabilities of CA$347.4m falling due after that. On the other hand, it had cash of CA$8.51m and CA$35.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$378.8m.
When you consider that this deficiency exceeds the company’s CA$323.7m market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner’s social media. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price. Either way, since Pinnacle Renewable Energy does have more debt than cash, it’s worth keeping an eye on its balance sheet.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Pinnacle Renewable Energy shareholders face the double whammy of a high net debt to EBITDA ratio (7.42), and fairly weak interest coverage, since EBIT is just 1.46 times the interest expense. This means we’d consider it to have a heavy debt load. Worse, Pinnacle Renewable Energy’s EBIT was down 23% 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. 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 Pinnacle Renewable Energy’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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Pinnacle Renewable Energy 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.
To be frank both Pinnacle Renewable Energy’s conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And furthermore, its interest cover also fails to instill confidence. Considering all the factors previously mentioned, we think that Pinnacle Renewable Energy really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. Given our concerns about Pinnacle Renewable Energy’s debt levels, it seems only prudent to check if insiders have been ditching the stock.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.