Flour Mills Kepenos (ATH:KEPEN) Has A Somewhat Strained Balance Sheet

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Flour Mills Kepenos S.A. (ATH:KEPEN) does use debt in its business. But should shareholders be worried about its use of debt?

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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Flour Mills Kepenos

How Much Debt Does Flour Mills Kepenos Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 Flour Mills Kepenos had €12.6m of debt, an increase on €10.9m, over one year. However, because it has a cash reserve of €1.35m, its net debt is less, at about €11.2m.

How Healthy Is Flour Mills Kepenos' Balance Sheet?

According to the last reported balance sheet, Flour Mills Kepenos had liabilities of €2.71m due within 12 months, and liabilities of €18.5m due beyond 12 months. Offsetting these obligations, it had cash of €1.35m as well as receivables valued at €16.0m due within 12 months. So it has liabilities totalling €3.80m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Flour Mills Kepenos is worth €13.9m, and thus could probably raise enough capital to shore up 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Flour Mills Kepenos has a debt to EBITDA ratio of 4.4 and its EBIT covered its interest expense 7.0 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. The bad news is that Flour Mills Kepenos saw its EBIT decline by 13% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Flour Mills Kepenos will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Flour Mills Kepenos saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Mulling over Flour Mills Kepenos's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that Flour Mills Kepenos's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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 Flour Mills Kepenos is showing 3 warning signs in our investment analysis , and 1 of those is a bit unpleasant...

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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