Is Grupa Azoty Zaklady Chemiczne Police (WSE:PCE) Using Too Much Debt?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Grupa Azoty Zaklady Chemiczne Police S.A. (WSE:PCE) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Grupa Azoty Zaklady Chemiczne Police

What Is Grupa Azoty Zaklady Chemiczne Police's Debt?

You can click the graphic below for the historical numbers, but it shows that Grupa Azoty Zaklady Chemiczne Police had zł733.1m of debt in September 2021, down from zł791.0m, one year before. However, because it has a cash reserve of zł64.9m, its net debt is less, at about zł668.2m.

A Look At Grupa Azoty Zaklady Chemiczne Police's Liabilities

The latest balance sheet data shows that Grupa Azoty Zaklady Chemiczne Police had liabilities of zł1.10b due within a year, and liabilities of zł639.7m falling due after that. On the other hand, it had cash of zł64.9m and zł491.6m worth of receivables due within a year. So its liabilities total zł1.19b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of zł1.45b, so it does suggest shareholders should keep an eye on Grupa Azoty Zaklady Chemiczne Police's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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 Zaklady Chemiczne Police's net debt is 2.8 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 1k times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Notably, Grupa Azoty Zaklady Chemiczne Police's EBIT launched higher than Elon Musk, gaining a whopping 179% on last year. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Grupa Azoty Zaklady Chemiczne Police 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, 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. During the last three years, Grupa Azoty Zaklady Chemiczne Police burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

While Grupa Azoty Zaklady Chemiczne Police's conversion of EBIT to free cash flow has us nervous. For example, its interest cover and EBIT growth rate give us some confidence in its ability to manage its debt. We think that Grupa Azoty Zaklady Chemiczne Police's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Grupa Azoty Zaklady Chemiczne Police's earnings per share history for free.

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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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.