These 4 Measures Indicate That Polimex-Mostostal (WSE:PXM) Is Using Debt Extensively

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.' 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 Polimex-Mostostal S.A. (WSE:PXM) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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.

Check out our latest analysis for Polimex-Mostostal

What Is Polimex-Mostostal's Debt?

The image below, which you can click on for greater detail, shows that at June 2020 Polimex-Mostostal had debt of zł421.1m, up from zł403.7m in one year. However, it also had zł338.4m in cash, and so its net debt is zł82.7m.

How Strong Is Polimex-Mostostal's Balance Sheet?

We can see from the most recent balance sheet that Polimex-Mostostal had liabilities of zł790.0m falling due within a year, and liabilities of zł288.4m due beyond that. On the other hand, it had cash of zł338.4m and zł462.4m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by zł277.7m.

This deficit isn't so bad because Polimex-Mostostal is worth zł562.0m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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).

While Polimex-Mostostal's low debt to EBITDA ratio of 0.95 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 2.6 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Pleasingly, Polimex-Mostostal is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 7,891% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is Polimex-Mostostal'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Polimex-Mostostal saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Neither Polimex-Mostostal's ability to convert EBIT to free cash flow nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. We think that Polimex-Mostostal's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. Like risks, for instance. Every company has them, and we've spotted 3 warning signs for Polimex-Mostostal (of which 1 is a bit concerning!) you should know about.

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.

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