Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Prim, S.A. (BME:PRM) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is Prim's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2020 Prim had €17.5m of debt, an increase on €6.06m, over one year. But it also has €35.2m in cash to offset that, meaning it has €17.7m net cash.
How Strong Is Prim's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Prim had liabilities of €37.9m due within 12 months and liabilities of €14.0m due beyond that. Offsetting these obligations, it had cash of €35.2m as well as receivables valued at €39.1m due within 12 months. So it actually has €22.3m more liquid assets than total liabilities.
This short term liquidity is a sign that Prim could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Prim boasts net cash, so it's fair to say it does not have a heavy debt load!
On the other hand, Prim saw its EBIT drop by 6.5% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Prim's earnings that will influence how the balance sheet holds up in the future. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Prim has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Looking at the most recent three years, Prim recorded free cash flow of 28% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
While we empathize with investors who find debt concerning, you should keep in mind that Prim has net cash of €17.7m, as well as more liquid assets than liabilities. So we don't have any problem with Prim's use of debt. 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. For example, we've discovered 3 warning signs for Prim (1 is a bit unpleasant!) that you should be aware of before investing here.
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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