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. As with many other companies Torpol S.A. (WSE:TOR) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Torpol's Debt?
The image below, which you can click on for greater detail, shows that Torpol had debt of zł40.0m at the end of September 2020, a reduction from zł111.1m over a year. But it also has zł354.3m in cash to offset that, meaning it has zł314.3m net cash.
A Look At Torpol's Liabilities
Zooming in on the latest balance sheet data, we can see that Torpol had liabilities of zł757.0m due within 12 months and liabilities of zł108.5m due beyond that. Offsetting these obligations, it had cash of zł354.3m as well as receivables valued at zł475.1m due within 12 months. So its liabilities total zł36.2m more than the combination of its cash and short-term receivables.
Since publicly traded Torpol shares are worth a total of zł287.1m, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, Torpol boasts net cash, so it's fair to say it does not have a heavy debt load!
On the other hand, Torpol saw its EBIT drop by 9.2% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Torpol's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. Torpol may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Torpol actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Although Torpol's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of zł314.3m. And it impressed us with free cash flow of zł363m, being 115% of its EBIT. So we don't have any problem with Torpol's use of debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Torpol is showing 4 warning signs in our investment analysis , and 1 of those is concerning...
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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