Is Grupa Azoty (WSE:ATT) Using Too Much Debt?

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.' 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. We can see that Grupa Azoty S.A. (WSE:ATT) does use debt in its business. But is this debt a concern to shareholders?

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. 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. 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.

See our latest analysis for Grupa Azoty

What Is Grupa Azoty's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Grupa Azoty had zł3.65b of debt, an increase on zł3.14b, over one year. However, because it has a cash reserve of zł576.2m, its net debt is less, at about zł3.08b.

A Look At Grupa Azoty's Liabilities

We can see from the most recent balance sheet that Grupa Azoty had liabilities of zł3.57b falling due within a year, and liabilities of zł4.76b due beyond that. Offsetting this, it had zł576.2m in cash and zł1.45b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by zł6.30b.

The deficiency here weighs heavily on the zł2.95b 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. At the end of the day, Grupa Azoty would probably need a major re-capitalization if its creditors were to demand repayment.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Grupa Azoty's debt is 2.5 times its EBITDA, and its EBIT cover its interest expense 5.7 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. The bad news is that Grupa Azoty saw its EBIT decline by 16% over the last year. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Grupa Azoty can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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, Grupa Azoty recorded free cash flow worth a fulsome 87% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

To be frank both Grupa Azoty's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Looking at the bigger picture, it seems clear to us that Grupa Azoty's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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 - Grupa Azoty has 2 warning signs we think you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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