Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Eurocash S.A. (WSE:EUR) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. When we think about a company's use of debt, we first look at cash and debt together.
See our latest analysis for Eurocash
How Much Debt Does Eurocash Carry?
You can click the graphic below for the historical numbers, but it shows that as of March 2021 Eurocash had zł1.02b of debt, an increase on zł863.4m, over one year. However, because it has a cash reserve of zł115.8m, its net debt is less, at about zł906.0m.
How Healthy Is Eurocash's Balance Sheet?
We can see from the most recent balance sheet that Eurocash had liabilities of zł5.03b falling due within a year, and liabilities of zł2.34b due beyond that. Offsetting this, it had zł115.8m in cash and zł1.61b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by zł5.64b.
The deficiency here weighs heavily on the zł1.75b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Eurocash would likely require a major re-capitalisation if it had to pay its creditors today.
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).
Even though Eurocash's debt is only 2.0, its interest cover is really very low at 2.3. This does have us wondering if the company pays high interest because it is considered risky. In any case, it's safe to say the company has meaningful debt. Notably Eurocash's EBIT was pretty flat over the last year. We would prefer to see some earnings growth, because that always helps diminish debt. 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 Eurocash's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
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. Over the last three years, Eurocash 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
Mulling over Eurocash's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Eurocash's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Eurocash is showing 3 warning signs in our investment analysis , and 1 of those doesn't sit too well with us...
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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About WSE:EUR
Eurocash
Engages in the wholesale distribution of food and other fast moving consumer goods (FMCG) in Poland.
Undervalued with moderate growth potential.