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 Zaklady Magnezytowe ROPCZYCE S.A. (WSE:RPC) does have debt on its balance sheet. 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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Zaklady Magnezytowe ROPCZYCE Carry?
The image below, which you can click on for greater detail, shows that Zaklady Magnezytowe ROPCZYCE had debt of zł50.1m at the end of September 2020, a reduction from zł75.3m over a year. However, it does have zł36.0m in cash offsetting this, leading to net debt of about zł14.1m.
A Look At Zaklady Magnezytowe ROPCZYCE's Liabilities
According to the last reported balance sheet, Zaklady Magnezytowe ROPCZYCE had liabilities of zł86.9m due within 12 months, and liabilities of zł53.8m due beyond 12 months. Offsetting these obligations, it had cash of zł36.0m as well as receivables valued at zł72.8m due within 12 months. So it has liabilities totalling zł31.9m more than its cash and near-term receivables, combined.
This deficit isn't so bad because Zaklady Magnezytowe ROPCZYCE is worth zł93.6m, 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.
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).
Zaklady Magnezytowe ROPCZYCE has a low net debt to EBITDA ratio of only 0.37. And its EBIT easily covers its interest expense, being 29.1 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, Zaklady Magnezytowe ROPCZYCE's EBIT dived 10%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. 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 Zaklady Magnezytowe ROPCZYCE 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Zaklady Magnezytowe ROPCZYCE produced sturdy free cash flow equating to 70% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Happily, Zaklady Magnezytowe ROPCZYCE's impressive interest cover implies it has the upper hand on its debt. But the stark truth is that we are concerned by its EBIT growth rate. All these things considered, it appears that Zaklady Magnezytowe ROPCZYCE can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Zaklady Magnezytowe ROPCZYCE is showing 2 warning signs in our investment analysis , you should know about...
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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