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. We note that Polaris Infrastructure Inc. (TSE:PIF) does have debt on its balance sheet. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Polaris Infrastructure Carry?
The chart below, which you can click on for greater detail, shows that Polaris Infrastructure had US$183.0m in debt in March 2021; about the same as the year before. On the flip side, it has US$108.0m in cash leading to net debt of about US$75.0m.
How Strong Is Polaris Infrastructure's Balance Sheet?
We can see from the most recent balance sheet that Polaris Infrastructure had liabilities of US$32.6m falling due within a year, and liabilities of US$225.1m due beyond that. Offsetting these obligations, it had cash of US$108.0m as well as receivables valued at US$10.9m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$138.8m.
Polaris Infrastructure has a market capitalization of US$296.3m, 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Polaris Infrastructure has a very low debt to EBITDA ratio of 1.5 so it is strange to see weak interest coverage, with last year's EBIT being only 1.7 times the interest expense. So one way or the other, it's clear the debt levels are not trivial. Shareholders should be aware that Polaris Infrastructure's EBIT was down 26% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Polaris Infrastructure can strengthen its balance sheet over time. 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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Polaris Infrastructure produced sturdy free cash flow equating to 65% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
On the face of it, Polaris Infrastructure's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Polaris Infrastructure stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 5 warning signs for Polaris Infrastructure (of which 1 is a bit concerning!) you should know about.
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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