Stock Analysis

Here's Why BasicNet (BIT:BAN) Has A Meaningful Debt Burden

BIT:BAN
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Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies BasicNet S.p.A. (BIT:BAN) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

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How Much Debt Does BasicNet Carry?

The chart below, which you can click on for greater detail, shows that BasicNet had €80.9m in debt in June 2020; about the same as the year before. However, it does have €19.9m in cash offsetting this, leading to net debt of about €61.0m.

debt-equity-history-analysis
BIT:BAN Debt to Equity History December 1st 2020

A Look At BasicNet's Liabilities

We can see from the most recent balance sheet that BasicNet had liabilities of €151.0m falling due within a year, and liabilities of €53.7m due beyond that. Offsetting this, it had €19.9m in cash and €63.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €121.2m.

This deficit is considerable relative to its market capitalization of €191.7m, so it does suggest shareholders should keep an eye on BasicNet's use of debt. 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).

BasicNet has a debt to EBITDA ratio of 3.5, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 13.7 is very high, suggesting that the interest expense on the debt is currently quite low. Importantly, BasicNet's EBIT fell a jaw-dropping 55% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since BasicNet will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, BasicNet recorded free cash flow worth 65% 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

Neither BasicNet's ability to grow its EBIT nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that BasicNet is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We've identified 4 warning signs with BasicNet , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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