These 4 Measures Indicate That Mercor (WSE:MCR) Is Using Debt Reasonably Well

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 note that Mercor S.A. (WSE:MCR) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 Mercor

What Is Mercor's Net Debt?

As you can see below, Mercor had zł68.6m of debt at September 2020, down from zł77.6m a year prior. However, it does have zł30.4m in cash offsetting this, leading to net debt of about zł38.2m.

How Strong Is Mercor's Balance Sheet?

We can see from the most recent balance sheet that Mercor had liabilities of zł108.5m falling due within a year, and liabilities of zł73.3m due beyond that. Offsetting this, it had zł30.4m in cash and zł91.4m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by zł60.0m.

While this might seem like a lot, it is not so bad since Mercor has a market capitalization of zł204.0m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without 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).

Mercor has a low net debt to EBITDA ratio of only 0.77. And its EBIT covers its interest expense a whopping 17.7 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, Mercor grew its EBIT by 44% 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 Mercor 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Mercor produced sturdy free cash flow equating to 55% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

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! Zooming out, Mercor seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. 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 risks, for instance. Every company has them, and we've spotted 4 warning signs for Mercor you should know about.

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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