Stock Analysis

Is Internity (WSE:INT) Using Too Much Debt?

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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.' 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. As with many other companies Internity S.A. (WSE:INT) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. 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.

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How Much Debt Does Internity Carry?

As you can see below, Internity had zł8.84m of debt at June 2021, down from zł10.1m a year prior. But it also has zł10.0m in cash to offset that, meaning it has zł1.18m net cash.

WSE:INT Debt to Equity History October 30th 2021

A Look At Internity's Liabilities

We can see from the most recent balance sheet that Internity had liabilities of zł38.1m falling due within a year, and liabilities of zł1.79m due beyond that. Offsetting this, it had zł10.0m in cash and zł5.43m in receivables that were due within 12 months. So its liabilities total zł24.4m more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of zł38.6m, so it does suggest shareholders should keep an eye on Internity's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. Despite its noteworthy liabilities, Internity boasts net cash, so it's fair to say it does not have a heavy debt load!

On top of that, Internity grew its EBIT by 77% over the last twelve months, and that growth will make it easier to handle its debt. 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. While Internity has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the most recent three years, Internity recorded free cash flow worth 74% 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.

Summing up

Although Internity's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of zł1.18m. And it impressed us with its EBIT growth of 77% over the last year. So is Internity's debt a risk? It doesn't seem so to us. 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. We've identified 2 warning signs with Internity (at least 1 which doesn't sit too well with us) , 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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