Is Zaklady Urzadzen Komputerowych ELZAB (WSE:ELZ) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Zaklady Urzadzen Komputerowych ELZAB S.A. (WSE:ELZ) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 Zaklady Urzadzen Komputerowych ELZAB

What Is Zaklady Urzadzen Komputerowych ELZAB's Net Debt?

As you can see below, Zaklady Urzadzen Komputerowych ELZAB had zł71.9m of debt at December 2020, down from zł87.9m a year prior. However, because it has a cash reserve of zł3.96m, its net debt is less, at about zł68.0m.

How Healthy Is Zaklady Urzadzen Komputerowych ELZAB's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Zaklady Urzadzen Komputerowych ELZAB had liabilities of zł84.6m due within 12 months and liabilities of zł17.2m due beyond that. Offsetting this, it had zł3.96m in cash and zł54.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by zł43.8m.

While this might seem like a lot, it is not so bad since Zaklady Urzadzen Komputerowych ELZAB has a market capitalization of zł76.0m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). 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).

With a net debt to EBITDA ratio of 6.2, it's fair to say Zaklady Urzadzen Komputerowych ELZAB does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 3.3 times, suggesting it can responsibly service its obligations. Another concern for investors might be that Zaklady Urzadzen Komputerowych ELZAB's EBIT fell 18% in the last year. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Zaklady Urzadzen Komputerowych ELZAB'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent two years, Zaklady Urzadzen Komputerowych ELZAB recorded free cash flow worth 78% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

To be frank both Zaklady Urzadzen Komputerowych ELZAB's EBIT growth rate and its track record of managing its debt, based on its EBITDA, make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Zaklady Urzadzen Komputerowych ELZAB stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 3 warning signs for Zaklady Urzadzen Komputerowych ELZAB you should be aware of, and 1 of them doesn't sit too well with us.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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This article by Simply Wall St is general in nature. 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.
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