Here's Why ERG Spólka Akcyjna (WSE:ERG) Has A Meaningful Debt Burden

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 note that ERG Spólka Akcyjna (WSE:ERG) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for ERG Spólka Akcyjna

How Much Debt Does ERG Spólka Akcyjna Carry?

As you can see below, ERG Spólka Akcyjna had zł7.74m of debt at March 2023, down from zł12.3m a year prior. However, because it has a cash reserve of zł878.0k, its net debt is less, at about zł6.86m.

How Strong Is ERG Spólka Akcyjna's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that ERG Spólka Akcyjna had liabilities of zł24.0m due within 12 months and liabilities of zł17.7m due beyond that. Offsetting this, it had zł878.0k in cash and zł16.2m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by zł24.6m.

This is a mountain of leverage relative to its market capitalization of zł39.4m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Looking at its net debt to EBITDA of 0.74 and interest cover of 2.7 times, it seems to us that ERG Spólka Akcyjna is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. We note that ERG Spólka Akcyjna grew its EBIT by 30% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since ERG Spólka Akcyjna 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, ERG Spólka Akcyjna saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

ERG Spólka Akcyjna's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. In particular, its EBIT growth rate was re-invigorating. Looking at all the angles mentioned above, it does seem to us that ERG Spólka Akcyjna is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. For example, we've discovered 3 warning signs for ERG Spólka Akcyjna (2 are significant!) that you should be aware of before investing here.

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.