Here's Why Papoutsanis (ATH:PAP) Can Manage Its Debt Responsibly

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.' 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 Papoutsanis S.A. (ATH:PAP) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Papoutsanis

What Is Papoutsanis's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Papoutsanis had €10.8m of debt, an increase on €9.33m, over one year. However, because it has a cash reserve of €2.88m, its net debt is less, at about €7.90m.

A Look At Papoutsanis's Liabilities

The latest balance sheet data shows that Papoutsanis had liabilities of €12.9m due within a year, and liabilities of €15.4m falling due after that. Offsetting this, it had €2.88m in cash and €8.65m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €16.7m.

Papoutsanis has a market capitalization of €63.3m, 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.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Papoutsanis's net debt is only 1.1 times its EBITDA. And its EBIT easily covers its interest expense, being 12.5 times the size. So we're pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that Papoutsanis grew its EBIT by 195% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Papoutsanis's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Papoutsanis created free cash flow amounting to 4.1% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

The good news is that Papoutsanis's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. Looking at all the aforementioned factors together, it strikes us that Papoutsanis can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Papoutsanis you should be aware of.

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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