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Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ 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. Importantly, Trans Polonia S.A. (WSE:TRN) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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 Trans Polonia Carry?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 Trans Polonia had zł130.7m of debt, an increase on zł85.1m, over one year. However, it does have zł44.2m in cash offsetting this, leading to net debt of about zł86.5m.
How Healthy Is Trans Polonia’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Trans Polonia had liabilities of zł68.0m due within 12 months and liabilities of zł105.3m due beyond that. Offsetting this, it had zł44.2m in cash and zł62.2m in receivables that were due within 12 months. So its liabilities total zł67.0m more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of zł79.8m. So should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. Either way, since Trans Polonia does have more debt than cash, it’s worth keeping an eye on its balance sheet.
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).
Trans Polonia’s debt is only 2.98 times its EBITDA, and its EBIT cover its interest expense 3.13 times over. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. On a lighter note, we note that Trans Polonia grew its EBIT by 30% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Trans Polonia’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, 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. Over the most recent three years, Trans Polonia recorded free cash flow worth 70% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
When it comes to the balance sheet, the standout positive for Trans Polonia was the fact that it seems able to grow its EBIT confidently. However, our other observations weren’t so heartening. For example, its interest cover makes us a little nervous about its debt. Looking at all this data makes us feel a little cautious about Trans Polonia’s debt levels. 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. Given Trans Polonia has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
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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If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.