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 note that Thrace Plastics Holding and Commercial S.A. (ATH:PLAT) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does Thrace Plastics Holding and Commercial Carry?
As you can see below, Thrace Plastics Holding and Commercial had €90.3m of debt, at March 2019, which is about the same the year before. You can click the chart for greater detail. However, because it has a cash reserve of €18.7m, its net debt is less, at about €71.6m.
A Look At Thrace Plastics Holding and Commercial’s Liabilities
We can see from the most recent balance sheet that Thrace Plastics Holding and Commercial had liabilities of €139.2m falling due within a year, and liabilities of €56.3m due beyond that. Offsetting these obligations, it had cash of €18.7m as well as receivables valued at €68.5m due within 12 months. So it has liabilities totalling €108.3m more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company’s €91.0m market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner’s social media. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Thrace Plastics Holding and Commercial has a debt to EBITDA ratio of 2.6 and its EBIT covered its interest expense 3.1 times. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. Worse, Thrace Plastics Holding and Commercial’s EBIT was down 28% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Thrace Plastics Holding and Commercial’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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. During the last three years, Thrace Plastics Holding and Commercial burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, Thrace Plastics Holding and Commercial’s conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least its net debt to EBITDA is not so bad. Taking into account all the aforementioned factors, it looks like Thrace Plastics Holding and Commercial has too much debt. That sort of riskiness is ok for some, but it certainly doesn’t float our boat. Over time, share prices tend to follow earnings per share, so if you’re interested in Thrace Plastics Holding and Commercial, you may well want to click here to check an interactive graph of its earnings per share history.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.