Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Piaggio & C. SpA (BIT:PIA) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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.
See our latest analysis for Piaggio & C
What Is Piaggio & C's Net Debt?
As you can see below, at the end of September 2020, Piaggio & C had €680.4m of debt, up from €597.0m a year ago. Click the image for more detail. On the flip side, it has €260.1m in cash leading to net debt of about €420.4m.
How Healthy Is Piaggio & C's Balance Sheet?
The latest balance sheet data shows that Piaggio & C had liabilities of €659.9m due within a year, and liabilities of €642.8m falling due after that. Offsetting this, it had €260.1m in cash and €142.6m in receivables that were due within 12 months. So its liabilities total €900.1m more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of €964.2m, so it does suggest shareholders should keep an eye on Piaggio & C's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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.
Piaggio & C has a debt to EBITDA ratio of 3.0 and its EBIT covered its interest expense 3.7 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Worse, Piaggio & C's EBIT was down 27% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Piaggio & C can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Piaggio & C recorded free cash flow of 35% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Our View
Mulling over Piaggio & C's attempt at (not) growing its EBIT, we're certainly not enthusiastic. Having said that, its ability to convert EBIT to free cash flow isn't such a worry. Overall, it seems to us that Piaggio & C's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Piaggio & C is showing 3 warning signs in our investment analysis , and 1 of those is significant...
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.
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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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About BIT:PIA
Piaggio & C
Engages in development, manufacture, and distribution of two-wheeler and commercial motor vehicles.
Fair value with mediocre balance sheet.