Is Aquafil (BIT:ECNL) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, Aquafil S.p.A. (BIT:ECNL) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Aquafil

What Is Aquafil's Debt?

The image below, which you can click on for greater detail, shows that at March 2023 Aquafil had debt of €375.3m, up from €344.9m in one year. However, it does have €122.8m in cash offsetting this, leading to net debt of about €252.5m.

A Look At Aquafil's Liabilities

The latest balance sheet data shows that Aquafil had liabilities of €231.9m due within a year, and liabilities of €310.2m falling due after that. On the other hand, it had cash of €122.8m and €35.8m worth of receivables due within a year. So it has liabilities totalling €383.5m more than its cash and near-term receivables, combined.

This deficit casts a shadow over the €219.2m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Aquafil would likely require a major re-capitalisation if it had to pay its creditors today.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Aquafil's debt is 3.3 times its EBITDA, and its EBIT cover its interest expense 4.8 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. We saw Aquafil grow its EBIT by 9.2% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off 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 Aquafil 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. In the last three years, Aquafil's free cash flow amounted to 43% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

We'd go so far as to say Aquafil's level of total liabilities was disappointing. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Aquafil's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 3 warning signs we've spotted with Aquafil (including 1 which makes us a bit uncomfortable) .

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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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.