paragon GmbH KGaA (ETR:PGN) Seems To Be Using A Lot Of Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that paragon GmbH & Co. KGaA (ETR:PGN) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for paragon GmbH KGaA

What Is paragon GmbH KGaA's Debt?

As you can see below, paragon GmbH KGaA had €60.5m of debt at June 2023, down from €92.7m a year prior. And it doesn't have much cash, so its net debt is about the same.

A Look At paragon GmbH KGaA's Liabilities

Zooming in on the latest balance sheet data, we can see that paragon GmbH KGaA had liabilities of €76.6m due within 12 months and liabilities of €43.5m due beyond that. Offsetting these obligations, it had cash of €563.0k as well as receivables valued at €9.77m due within 12 months. So it has liabilities totalling €109.8m more than its cash and near-term receivables, combined.

This deficit casts a shadow over the €26.5m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, paragon GmbH KGaA 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 0.10 times and a disturbingly high net debt to EBITDA ratio of 6.8 hit our confidence in paragon GmbH KGaA like a one-two punch to the gut. The debt burden here is substantial. One redeeming factor for paragon GmbH KGaA is that it turned last year's EBIT loss into a gain of €730k, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if paragon GmbH KGaA 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, paragon GmbH KGaA burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, paragon GmbH KGaA's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least its EBIT growth rate is not so bad. We think the chances that paragon GmbH KGaA has too much debt a very significant. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 2 warning signs we've spotted with paragon GmbH KGaA (including 1 which is concerning) .

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. 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.