Is Panama Petrochem (NSE:PANAMAPET) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Panama Petrochem Limited (NSE:PANAMAPET) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Panama Petrochem

What Is Panama Petrochem's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Panama Petrochem had ₹493.9m of debt in September 2020, down from ₹1.42b, one year before. However, it does have ₹410.1m in cash offsetting this, leading to net debt of about ₹83.8m.

How Strong Is Panama Petrochem's Balance Sheet?

According to the last reported balance sheet, Panama Petrochem had liabilities of ₹2.99b due within 12 months, and liabilities of ₹81.0m due beyond 12 months. Offsetting this, it had ₹410.1m in cash and ₹2.63b in receivables that were due within 12 months. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.

This state of affairs indicates that Panama Petrochem's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the ₹8.30b company is struggling for cash, we still think it's worth monitoring its balance sheet. But either way, Panama Petrochem has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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.

Panama Petrochem has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.067 and EBIT of 17.0 times the interest expense. So relative to past earnings, the debt load seems trivial. In addition to that, we're happy to report that Panama Petrochem has boosted its EBIT by 73%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Panama Petrochem 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Panama Petrochem's free cash flow amounted to 49% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Panama Petrochem's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Looking at the bigger picture, we think Panama Petrochem's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Panama Petrochem you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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