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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Mercor S.A. (WSE:MCR) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Mercor's Debt?
As you can see below, Mercor had zł65.8m of debt at December 2020, down from zł74.4m a year prior. However, because it has a cash reserve of zł27.3m, its net debt is less, at about zł38.5m.
How Strong Is Mercor's Balance Sheet?
We can see from the most recent balance sheet that Mercor had liabilities of zł86.4m falling due within a year, and liabilities of zł77.1m due beyond that. Offsetting this, it had zł27.3m in cash and zł80.8m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by zł55.4m.
Of course, Mercor has a market capitalization of zł291.7m, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).
Mercor's net debt is only 0.75 times its EBITDA. And its EBIT covers its interest expense a whopping 16.9 times over. So we're pretty relaxed about its super-conservative use of debt. In addition to that, we're happy to report that Mercor has boosted its EBIT by 57%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But it is Mercor's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs 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, Mercor recorded free cash flow worth 59% 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.
Happily, Mercor's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its EBIT growth rate also supports that impression! Looking at the bigger picture, we think Mercor's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. 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. To that end, you should be aware of the 2 warning signs we've spotted with Mercor .
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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