Here’s Why Patentus (WSE:PAT) Can Manage Its Debt Responsibly

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Patentus S.A. (WSE:PAT) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.

Check out our latest analysis for Patentus

What Is Patentus’s Debt?

You can click the graphic below for the historical numbers, but it shows that Patentus had zł21.6m of debt in March 2019, down from zł37.2m, one year before However, it also had zł5.84m in cash, and so its net debt is zł15.8m.

WSE:PAT Historical Debt, July 24th 2019
WSE:PAT Historical Debt, July 24th 2019

How Healthy Is Patentus’s Balance Sheet?

According to the last reported balance sheet, Patentus had liabilities of zł25.4m due within 12 months, and liabilities of zł26.9m due beyond 12 months. On the other hand, it had cash of zł5.84m and zł22.5m worth of receivables due within a year. So its liabilities total zł24.0m more than the combination of its cash and short-term receivables.

This deficit isn’t so bad because Patentus is worth zł44.8m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution. Since Patentus does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, over time.

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.

Patentus has a low net debt to EBITDA ratio of only 0.92. And its EBIT covers its interest expense a whopping 10.8 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Better yet, Patentus grew its EBIT by 220% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. 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 Patentus 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 we always check how much of that EBIT is translated into free cash flow. During the last two years, Patentus burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Based on what we’ve seen Patentus is not finding it easy conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. There’s no doubt that its ability to grow its EBIT is pretty flash. Looking at all this data makes us feel a little cautious about Patentus’s debt levels. While we appreciate debt can enhance returns on equity, we’d suggest that shareholders keep close watch on its debt levels, lest they increase. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you’ve also come to that realization, you’re in luck, because today you can view this interactive graph of Patentus’s earnings per share history for free.

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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.