Is Componenta (HEL:CTH1V) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Componenta Corporation (HEL:CTH1V) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

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What Is Componenta's Debt?

You can click the graphic below for the historical numbers, but it shows that Componenta had €2.15m of debt in June 2022, down from €4.04m, one year before. However, its balance sheet shows it holds €5.11m in cash, so it actually has €2.96m net cash.

How Strong Is Componenta's Balance Sheet?

We can see from the most recent balance sheet that Componenta had liabilities of €24.1m falling due within a year, and liabilities of €9.50m due beyond that. Offsetting these obligations, it had cash of €5.11m as well as receivables valued at €6.01m due within 12 months. So its liabilities total €22.5m more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of €25.7m, so it does suggest shareholders should keep an eye on Componenta's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. Despite its noteworthy liabilities, Componenta boasts net cash, so it's fair to say it does not have a heavy debt load!

We also note that Componenta improved its EBIT from a last year's loss to a positive €704k. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Componenta 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Componenta may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last year, Componenta saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Summing Up

Although Componenta's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of €2.96m. Despite its cash we think that Componenta seems to struggle to convert EBIT to free cash flow, so we are wary of the stock. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Componenta is showing 4 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...

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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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.