These 4 Measures Indicate That Izostal (WSE:IZS) Is Using Debt Extensively

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. Importantly, Izostal S.A. (WSE:IZS) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. 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. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Izostal

What Is Izostal's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Izostal had zł91.9m of debt in September 2020, down from zł114.1m, one year before. However, because it has a cash reserve of zł16.6m, its net debt is less, at about zł75.3m.

A Look At Izostal's Liabilities

The latest balance sheet data shows that Izostal had liabilities of zł310.9m due within a year, and liabilities of zł38.6m falling due after that. On the other hand, it had cash of zł16.6m and zł176.9m worth of receivables due within a year. So it has liabilities totalling zł156.0m more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's zł113.6m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). 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).

Izostal has net debt to EBITDA of 2.7 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 7.8 suggests it can easily service that debt. One way Izostal could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 20%, as it did over the last year. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Izostal 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 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. Considering the last three years, Izostal actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

On the face of it, Izostal's level of total liabilities left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Izostal's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 4 warning signs we've spotted with Izostal .

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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