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. Importantly, Centrum Finansowe S.A. (WSE:CFS) does carry debt. But is this debt a concern to shareholders?
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. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Centrum Finansowe Carry?
You can click the graphic below for the historical numbers, but it shows that as of December 2020 Centrum Finansowe had zł15.4m of debt, an increase on zł5.50m, over one year. On the flip side, it has zł14.9m in cash leading to net debt of about zł573.1k.
How Strong Is Centrum Finansowe's Balance Sheet?
According to the last reported balance sheet, Centrum Finansowe had liabilities of zł3.21m due within 12 months, and liabilities of zł13.3m due beyond 12 months. Offsetting these obligations, it had cash of zł14.9m as well as receivables valued at zł654.7k due within 12 months. So it has liabilities totalling zł956.0k more than its cash and near-term receivables, combined.
Since publicly traded Centrum Finansowe shares are worth a total of zł32.6m, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Centrum Finansowe has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.061 and EBIT of 10.0 times the interest expense. So relative to past earnings, the debt load seems trivial. In addition to that, we're happy to report that Centrum Finansowe has boosted its EBIT by 41%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But it is Centrum Finansowe's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Centrum Finansowe actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
The good news is that Centrum Finansowe's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. We think Centrum Finansowe is no more beholden to its lenders, than the birds are to birdwatchers. To our minds it has a healthy happy balance sheet. 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 3 warning signs with Centrum Finansowe (at least 1 which shouldn't be ignored) , and understanding them should be part of your investment process.
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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