Papoutsanis (ATH:PAP) Takes On Some Risk With Its Use Of Debt

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. So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Papoutsanis S.A. (ATH:PAP) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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.

View our latest analysis for Papoutsanis

What Is Papoutsanis's Net Debt?

The image below, which you can click on for greater detail, shows that Papoutsanis had debt of €9.27m at the end of June 2019, a reduction from €11.0m over a year. On the flip side, it has €1.63m in cash leading to net debt of about €7.63m.

A Look At Papoutsanis's Liabilities

The latest balance sheet data shows that Papoutsanis had liabilities of €13.3m due within a year, and liabilities of €11.0m falling due after that. Offsetting this, it had €1.63m in cash and €7.37m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €15.2m.

While this might seem like a lot, it is not so bad since Papoutsanis has a market capitalization of €38.7m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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

Papoutsanis's debt is 2.8 times its EBITDA, and its EBIT cover its interest expense 3.3 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. On a lighter note, we note that Papoutsanis grew its EBIT by 24% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. There's no doubt that we learn most about debt from the balance sheet. But it is Papoutsanis's earnings that will influence how the balance sheet holds up in the future. 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. During the last three years, Papoutsanis burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Papoutsanis's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. In particular, its EBIT growth rate was re-invigorating. Taking the abovementioned factors together we do think Papoutsanis's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Papoutsanis's earnings per share history for free.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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. Thank you for reading.