Is Fabryka Obrabiarek RAFAMET (WSE:RAF) A Risky Investment?

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.' 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 Fabryka Obrabiarek RAFAMET S.A. (WSE:RAF) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Fabryka Obrabiarek RAFAMET

What Is Fabryka Obrabiarek RAFAMET's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Fabryka Obrabiarek RAFAMET had zł40.4m of debt, an increase on zł34.8m, over one year. However, it does have zł2.24m in cash offsetting this, leading to net debt of about zł38.2m.

How Healthy Is Fabryka Obrabiarek RAFAMET's Balance Sheet?

According to the last reported balance sheet, Fabryka Obrabiarek RAFAMET had liabilities of zł86.6m due within 12 months, and liabilities of zł28.2m due beyond 12 months. On the other hand, it had cash of zł2.24m and zł91.2m worth of receivables due within a year. So its liabilities total zł21.4m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Fabryka Obrabiarek RAFAMET has a market capitalization of zł73.0m, 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.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While we wouldn't worry about Fabryka Obrabiarek RAFAMET's net debt to EBITDA ratio of 3.4, we think its super-low interest cover of 2.0 times is a sign of high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Even more troubling is the fact that Fabryka Obrabiarek RAFAMET actually let its EBIT decrease by 3.0% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Fabryka Obrabiarek RAFAMET'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Fabryka Obrabiarek RAFAMET created free cash flow amounting to 7.8% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

To be frank both Fabryka Obrabiarek RAFAMET's conversion of EBIT to free cash flow and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. But at least its level of total liabilities is not so bad. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Fabryka Obrabiarek RAFAMET stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example Fabryka Obrabiarek RAFAMET has 4 warning signs (and 2 which are concerning) we think 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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