Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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, Makarony Polskie S.A. (WSE:MAK) does carry debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.
What Is Makarony Polskie's Net Debt?
The image below, which you can click on for greater detail, shows that Makarony Polskie had debt of zł26.9m at the end of December 2020, a reduction from zł34.5m over a year. And it doesn't have much cash, so its net debt is about the same.
How Strong Is Makarony Polskie's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Makarony Polskie had liabilities of zł52.9m due within 12 months and liabilities of zł42.4m due beyond that. Offsetting this, it had zł410.0k in cash and zł22.4m in receivables that were due within 12 months. So it has liabilities totalling zł72.5m more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's market capitalization of zł63.5m, we think shareholders really should watch Makarony Polskie's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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.
Makarony Polskie's net debt is only 1.4 times its EBITDA. And its EBIT easily covers its interest expense, being 12.3 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, Makarony Polskie grew its EBIT by 60% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Makarony Polskie will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Makarony Polskie burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
We feel some trepidation about Makarony Polskie's difficulty conversion of EBIT to free cash flow, but we've got positives to focus on, too. For example, its interest cover and EBIT growth rate give us some confidence in its ability to manage its debt. Taking the abovementioned factors together we do think Makarony Polskie's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Makarony Polskie that you should be aware of before investing here.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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