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.' 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 can see that Internity S.A. (WSE:INT) does use debt in its business. But is this debt a concern to shareholders?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Internity's Net Debt?
As you can see below, Internity had zł10.9m of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of zł7.26m, its net debt is less, at about zł3.62m.
A Look At Internity's Liabilities
Zooming in on the latest balance sheet data, we can see that Internity had liabilities of zł29.6m due within 12 months and liabilities of zł2.17m due beyond that. Offsetting these obligations, it had cash of zł7.26m as well as receivables valued at zł5.93m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by zł18.6m.
This is a mountain of leverage relative to its market capitalization of zł21.7m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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.
Internity has a low net debt to EBITDA ratio of only 0.55. And its EBIT easily covers its interest expense, being 17.9 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Better yet, Internity grew its EBIT by 123% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Internity will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Internity generated free cash flow amounting to a very robust 90% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
Internity's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But truth be told we feel its level of total liabilities does undermine this impression a bit. Zooming out, Internity seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 3 warning signs we've spotted with Internity (including 1 which can't be ignored) .
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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