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.' 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. Importantly, PlanetMedia SA (EPA:ALPLA) does carry debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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.
What Is PlanetMedia's Net Debt?
The image below, which you can click on for greater detail, shows that PlanetMedia had debt of €4.44m at the end of June 2020, a reduction from €5.65m over a year. And it doesn't have much cash, so its net debt is about the same.
How Strong Is PlanetMedia's Balance Sheet?
The latest balance sheet data shows that PlanetMedia had liabilities of €4.18m due within a year, and liabilities of €3.75m falling due after that. Offsetting these obligations, it had cash of €11.4k as well as receivables valued at €5.25m due within 12 months. So its liabilities total €2.67m more than the combination of its cash and short-term receivables.
PlanetMedia has a market capitalization of €5.44m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
PlanetMedia has a debt to EBITDA ratio of 2.6 and its EBIT covered its interest expense 5.9 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Shareholders should be aware that PlanetMedia's EBIT was down 30% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since PlanetMedia 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, PlanetMedia basically broke even on a free cash flow basis. Some might say that's a concern, when it comes considering how easily it would be for it to down debt.
Mulling over PlanetMedia's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But at least its interest cover is not so bad. Looking at the bigger picture, it seems clear to us that PlanetMedia's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. Take risks, for example - PlanetMedia has 4 warning signs (and 3 which are concerning) we think you should know about.
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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