The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. Importantly, Amica S.A. (WSE:AMC) does carry debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Amica Carry?
You can click the graphic below for the historical numbers, but it shows that Amica had zł229.9m of debt in September 2020, down from zł387.3m, one year before. On the flip side, it has zł228.1m in cash leading to net debt of about zł1.80m.
A Look At Amica's Liabilities
Zooming in on the latest balance sheet data, we can see that Amica had liabilities of zł966.4m due within 12 months and liabilities of zł183.9m due beyond that. On the other hand, it had cash of zł228.1m and zł714.5m worth of receivables due within a year. So it has liabilities totalling zł207.7m more than its cash and near-term receivables, combined.
Given Amica has a market capitalization of zł1.09b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. But either way, Amica has virtually no net debt, so it's fair to say it does not have a heavy debt load!
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).
Amica has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.0077 and EBIT of 52.1 times the interest expense. So relative to past earnings, the debt load seems trivial. Also good is that Amica grew its EBIT at 19% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Amica can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs 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, Amica actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
The good news is that Amica's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Overall, we don't think Amica is taking any bad risks, as its debt load seems modest. So we're not worried about the use of a little leverage on the 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. For example - Amica has 1 warning sign we think you should be aware of.
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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