We Think F.I.L.A. - Fabbrica Italiana Lapis ed Affini (BIT:FILA) Is Taking Some Risk With Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 F.I.L.A. - Fabbrica Italiana Lapis ed Affini S.p.A. (BIT:FILA) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for F.I.L.A. - Fabbrica Italiana Lapis ed Affini

What Is F.I.L.A. - Fabbrica Italiana Lapis ed Affini's Net Debt?

You can click the graphic below for the historical numbers, but it shows that F.I.L.A. - Fabbrica Italiana Lapis ed Affini had €401.8m of debt in December 2020, down from €511.8m, one year before. However, it also had €88.6m in cash, and so its net debt is €313.1m.

How Healthy Is F.I.L.A. - Fabbrica Italiana Lapis ed Affini's Balance Sheet?

The latest balance sheet data shows that F.I.L.A. - Fabbrica Italiana Lapis ed Affini had liabilities of €100.5m due within a year, and liabilities of €576.7m falling due after that. Offsetting this, it had €88.6m in cash and €115.9m in receivables that were due within 12 months. So its liabilities total €472.7m more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of €509.4m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

While we wouldn't worry about F.I.L.A. - Fabbrica Italiana Lapis ed Affini's net debt to EBITDA ratio of 2.9, we think its super-low interest cover of 1.8 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Even worse, F.I.L.A. - Fabbrica Italiana Lapis ed Affini saw its EBIT tank 22% over the last 12 months. 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 F.I.L.A. - Fabbrica Italiana Lapis ed Affini'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, F.I.L.A. - Fabbrica Italiana Lapis ed Affini recorded free cash flow worth 79% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

To be frank both F.I.L.A. - Fabbrica Italiana Lapis ed Affini's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that F.I.L.A. - Fabbrica Italiana Lapis ed Affini's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. For example, we've discovered 3 warning signs for F.I.L.A. - Fabbrica Italiana Lapis ed Affini (1 is a bit concerning!) that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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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