These 4 Measures Indicate That KLON Spólka Akcyjna (WSE:KLN) Is Using Debt Reasonably Well

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 KLON Spólka Akcyjna (WSE:KLN) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for KLON Spólka Akcyjna

How Much Debt Does KLON Spólka Akcyjna Carry?

The image below, which you can click on for greater detail, shows that KLON Spólka Akcyjna had debt of zł10.5m at the end of December 2020, a reduction from zł14.6m over a year. However, because it has a cash reserve of zł669.8k, its net debt is less, at about zł9.83m.

How Strong Is KLON Spólka Akcyjna's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that KLON Spólka Akcyjna had liabilities of zł7.95m due within 12 months and liabilities of zł12.1m due beyond that. On the other hand, it had cash of zł669.8k and zł2.61m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by zł16.8m.

This deficit isn't so bad because KLON Spólka Akcyjna is worth zł40.6m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). 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).

While we wouldn't worry about KLON Spólka Akcyjna's net debt to EBITDA ratio of 3.5, we think its super-low interest cover of 1.1 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. The good news is that KLON Spólka Akcyjna improved its EBIT by 2.8% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since KLON Spólka Akcyjna will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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. During the last three years, KLON Spólka Akcyjna generated free cash flow amounting to a very robust 80% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

KLON Spólka Akcyjna's interest cover was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to convert EBIT to free cash flow is pretty flash. When we consider all the factors mentioned above, we do feel a bit cautious about KLON Spólka Akcyjna's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 5 warning signs for KLON Spólka Akcyjna (of which 2 are concerning!) you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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