Is Portale Sardegna (BIT:PSA) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 note that Portale Sardegna S.p.A. (BIT:PSA) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Portale Sardegna

What Is Portale Sardegna's Debt?

As you can see below, at the end of June 2021, Portale Sardegna had €7.32m of debt, up from €6.78m a year ago. Click the image for more detail. However, it also had €3.97m in cash, and so its net debt is €3.35m.

How Strong Is Portale Sardegna's Balance Sheet?

The latest balance sheet data shows that Portale Sardegna had liabilities of €4.06m due within a year, and liabilities of €7.31m falling due after that. Offsetting this, it had €3.97m in cash and €2.77m in receivables that were due within 12 months. So its liabilities total €4.63m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Portale Sardegna is worth €8.14m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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

While we wouldn't worry about Portale Sardegna's net debt to EBITDA ratio of 4.0, we think its super-low interest cover of 1.2 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. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. However, the silver lining was that Portale Sardegna achieved a positive EBIT of €362k in the last twelve months, an improvement on the prior year's loss. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Portale Sardegna'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Portale Sardegna burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Portale Sardegna's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. Overall, it seems to us that Portale Sardegna's balance sheet is really quite a risk to the business. 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. Be aware that Portale Sardegna is showing 2 warning signs in our investment analysis , 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.

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.

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