Does Industrias Peñoles. de (BMV:PE&OLES) Have A Healthy Balance Sheet?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies Industrias Peñoles, S.A.B. de C.V. (BMV:PE&OLES) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Industrias Peñoles. de

What Is Industrias Peñoles. de's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Industrias Peñoles. de had debt of US$2.61b, up from US$2.23b in one year. However, it does have US$1.13b in cash offsetting this, leading to net debt of about US$1.48b.

How Healthy Is Industrias Peñoles. de's Balance Sheet?

According to the last reported balance sheet, Industrias Peñoles. de had liabilities of US$923.0m due within 12 months, and liabilities of US$3.46b due beyond 12 months. Offsetting this, it had US$1.13b in cash and US$530.0m in receivables that were due within 12 months. So it has liabilities totalling US$2.72b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Industrias Peñoles. de has a market capitalization of US$6.24b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). 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 Industrias Peñoles. de's low debt to EBITDA ratio of 1.3 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.1 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Importantly, Industrias Peñoles. de grew its EBIT by 50% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Industrias Peñoles. de 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Considering the last three years, Industrias Peñoles. de actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

When it comes to the balance sheet, the standout positive for Industrias Peñoles. de was the fact that it seems able to grow its EBIT confidently. But the other factors we noted above weren't so encouraging. To be specific, it seems about as good at converting EBIT to free cash flow as wet socks are at keeping your feet warm. When we consider all the factors mentioned above, we do feel a bit cautious about Industrias Peñoles. de's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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 be aware of the 1 warning sign we've spotted with Industrias Peñoles. de .

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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