We Think Grupa Azoty (WSE:ATT) Is Taking Some Risk With Its Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. 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 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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Grupa Azoty

What Is Grupa Azoty's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Grupa Azoty had debt of zł3.65b, up from zł3.14b in one year. On the flip side, it has zł576.2m in cash leading to net debt of about zł3.08b.

A Look At Grupa Azoty's Liabilities

The latest balance sheet data shows that Grupa Azoty had liabilities of zł3.57b due within a year, and liabilities of zł4.76b falling due after that. On the other hand, it had cash of zł576.2m and zł1.45b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by zł6.30b.

This deficit casts a shadow over the zł2.56b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Grupa Azoty 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Grupa Azoty has a debt to EBITDA ratio of 2.5 and its EBIT covered its interest expense 5.7 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Unfortunately, Grupa Azoty's EBIT flopped 16% over the last four quarters. 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. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Grupa Azoty 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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Grupa Azoty generated free cash flow amounting to a very robust 87% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

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. Overall, we think it's fair to say that Grupa Azoty has enough debt that there are some real risks around the balance sheet. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 2 warning signs we've spotted with Grupa Azoty .

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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