David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the 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. Importantly, Papoutsanis S.A. (ATH:PAP) does carry debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.
What Is Papoutsanis’s Net Debt?
The image below, which you can click on for greater detail, shows that Papoutsanis had debt of €7.77m at the end of September 2019, a reduction from €9.72m over a year. However, because it has a cash reserve of €2.78m, its net debt is less, at about €4.99m.
A Look At Papoutsanis’s Liabilities
According to the last reported balance sheet, Papoutsanis had liabilities of €11.1m due within 12 months, and liabilities of €10.9m due beyond 12 months. Offsetting this, it had €2.78m in cash and €5.44m in receivables that were due within 12 months. So its liabilities total €13.9m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Papoutsanis has a market capitalization of €26.4m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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 sitting at a very reasonable 1.6 times its EBITDA, while its EBIT covered its interest expense just 4.4 times last year. While these numbers do not alarm us, it’s worth noting that the cost of the company’s debt is having a real impact. It is well worth noting that Papoutsanis’s EBIT shot up like bamboo after rain, gaining 57% in the last twelve months. That’ll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Papoutsanis’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, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Papoutsanis recorded free cash flow worth 65% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Happily, Papoutsanis’s impressive EBIT growth rate implies it has the upper hand on its debt. But truth be told we feel its level of total liabilities does undermine this impression a bit. All these things considered, it appears that Papoutsanis can comfortably handle its current debt levels. 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. Take risks, for example – Papoutsanis has 3 warning signs we think you should be aware of.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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