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 note that P.A. Nova S.A. (WSE:NVA) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. If things get really bad, the lenders can take control of the business. 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 P.A. Nova
What Is P.A. Nova's Net Debt?
As you can see below, P.A. Nova had zł354.3m of debt at September 2020, down from zł379.3m a year prior. However, it does have zł41.8m in cash offsetting this, leading to net debt of about zł312.5m.
How Strong Is P.A. Nova's Balance Sheet?
The latest balance sheet data shows that P.A. Nova had liabilities of zł97.4m due within a year, and liabilities of zł344.7m falling due after that. On the other hand, it had cash of zł41.8m and zł39.1m worth of receivables due within a year. So its liabilities total zł361.2m more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the zł127.1m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, P.A. Nova would likely require a major re-capitalisation if it had to pay its creditors today.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
P.A. Nova has a rather high debt to EBITDA ratio of 8.5 which suggests a meaningful debt load. However, its interest coverage of 6.8 is reasonably strong, which is a good sign. Importantly, P.A. Nova's EBIT fell a jaw-dropping 22% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since P.A. Nova will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, P.A. Nova reported free cash flow worth 8.2% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
Our View
To be frank both P.A. Nova's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. After considering the datapoints discussed, we think P.A. Nova has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 4 warning signs with P.A. Nova (at least 1 which is concerning) , and understanding them should be part of your investment process.
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.
When trading P.A. Nova or any other investment, use the platform considered by many to be the Professional's Gateway to the Worlds Market, Interactive Brokers. You get the lowest-cost* trading on stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted
New: Manage All Your Stock Portfolios in One Place
We've created the ultimate portfolio companion for stock investors, and it's free.
• Connect an unlimited number of Portfolios and see your total in one currency
• Be alerted to new Warning Signs or Risks via email or mobile
• Track the Fair Value of your stocks
This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
About WSE:NVA
Average dividend payer and fair value.
