Is Wikana (WSE:WIK) A Risky Investment?

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Wikana S.A. (WSE:WIK) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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 Wikana

What Is Wikana's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Wikana had debt of zł70.8m, up from zł65.3m in one year. However, it does have zł10.8m in cash offsetting this, leading to net debt of about zł60.1m.

A Look At Wikana's Liabilities

The latest balance sheet data shows that Wikana had liabilities of zł139.7m due within a year, and liabilities of zł43.7m falling due after that. Offsetting these obligations, it had cash of zł10.8m as well as receivables valued at zł6.05m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by zł166.6m.

This deficit casts a shadow over the zł54.9m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Wikana would likely require a major re-capitalisation if it had to pay its creditors today.

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). 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).

Weak interest cover of 1.1 times and a disturbingly high net debt to EBITDA ratio of 9.8 hit our confidence in Wikana like a one-two punch to the gut. The debt burden here is substantial. Even worse, Wikana saw its EBIT tank 38% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But it is Wikana'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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Wikana 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.

Our View

On the face of it, Wikana's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Taking into account all the aforementioned factors, it looks like Wikana has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. Be aware that Wikana is showing 3 warning signs in our investment analysis , and 1 of those is a bit concerning...

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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