Aquafil (BIT:ECNL) Use Of Debt Could Be Considered Risky

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 Aquafil S.p.A. (BIT:ECNL) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Aquafil's Debt?

The image below, which you can click on for greater detail, shows that Aquafil had debt of €315.8m at the end of December 2024, a reduction from €377.2m over a year. On the flip side, it has €130.6m in cash leading to net debt of about €185.1m.

A Look At Aquafil's Liabilities

According to the last reported balance sheet, Aquafil had liabilities of €232.3m due within 12 months, and liabilities of €264.6m due beyond 12 months. Offsetting these obligations, it had cash of €130.6m as well as receivables valued at €24.4m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €341.9m.

The deficiency here weighs heavily on the €123.5m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Aquafil would probably need a major re-capitalization if its creditors were to demand repayment.

Check out our latest analysis for Aquafil

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.

While we wouldn't worry about Aquafil's net debt to EBITDA ratio of 3.9, we think its super-low interest cover of 0.28 times is a sign of high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. However, the silver lining was that Aquafil achieved a positive EBIT of €5.5m in the last twelve months, an improvement on the prior year's loss. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Aquafil'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Aquafil saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Aquafil's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. Having said that, its ability to grow its EBIT isn't such a worry. Taking into account all the aforementioned factors, it looks like Aquafil has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. Case in point: We've spotted 3 warning signs for Aquafil you should be aware of, and 2 of them are a bit unpleasant.

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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.