Stock Analysis

Delko (WSE:DEL) Seems To Use Debt Quite Sensibly

WSE:DEL
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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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Delko S.A. (WSE:DEL) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Delko

How Much Debt Does Delko Carry?

You can click the graphic below for the historical numbers, but it shows that Delko had zł50.8m of debt in September 2021, down from zł59.8m, one year before. However, because it has a cash reserve of zł5.28m, its net debt is less, at about zł45.5m.

debt-equity-history-analysis
WSE:DEL Debt to Equity History March 4th 2022

How Healthy Is Delko's Balance Sheet?

According to the last reported balance sheet, Delko had liabilities of zł123.3m due within 12 months, and liabilities of zł29.4m due beyond 12 months. On the other hand, it had cash of zł5.28m and zł75.0m worth of receivables due within a year. So it has liabilities totalling zł72.4m more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of zł94.8m. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Delko's net debt is only 1.4 times its EBITDA. And its EBIT covers its interest expense a whopping 26.8 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the bad news is that Delko has seen its EBIT plunge 15% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. There's no doubt that we learn most about debt from the balance sheet. But it is Delko's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Delko actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Both Delko's ability to to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. But truth be told its EBIT growth rate had us nibbling our nails. Looking at all this data makes us feel a little cautious about Delko's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. For instance, we've identified 2 warning signs for Delko that you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.