These 4 Measures Indicate That Pirelli & C (BIT:PIRC) Is Using Debt Extensively

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.' 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 can see that Pirelli & C. S.p.A. (BIT:PIRC) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Pirelli & C

How Much Debt Does Pirelli & C Carry?

As you can see below, Pirelli & C had €4.60b of debt at March 2021, down from €5.14b a year prior. On the flip side, it has €755.8m in cash leading to net debt of about €3.85b.

How Healthy Is Pirelli & C's Balance Sheet?

According to the last reported balance sheet, Pirelli & C had liabilities of €1.98b due within 12 months, and liabilities of €5.89b due beyond 12 months. Offsetting these obligations, it had cash of €755.8m as well as receivables valued at €1.34b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €5.77b.

Given this deficit is actually higher than the company's market capitalization of €4.72b, we think shareholders really should watch Pirelli & C's debt levels, like a parent watching their child ride a bike for the first time. 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.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 2.2 times and a disturbingly high net debt to EBITDA ratio of 5.9 hit our confidence in Pirelli & C like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Worse, Pirelli & C's EBIT was down 63% 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 Pirelli & 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Pirelli & C generated free cash flow amounting to a very robust 87% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

On the face of it, Pirelli & C's net debt to EBITDA 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 on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. We're quite clear that we consider Pirelli & C to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for Pirelli & C (of which 1 is a bit concerning!) you should know about.

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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