Is Zespól Elektrocieplowni Wroclawskich KOGENERACJA (WSE:KGN) A Risky Investment?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 Zespól Elektrocieplowni Wroclawskich KOGENERACJA S.A. (WSE:KGN) makes use of debt. But the more important question is: how much risk is that debt creating?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Zespól Elektrocieplowni Wroclawskich KOGENERACJA

What Is Zespól Elektrocieplowni Wroclawskich KOGENERACJA's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2022 Zespól Elektrocieplowni Wroclawskich KOGENERACJA had debt of zł21.4m, up from none in one year. However, it also had zł5.17m in cash, and so its net debt is zł16.2m.

A Look At Zespól Elektrocieplowni Wroclawskich KOGENERACJA's Liabilities

The latest balance sheet data shows that Zespól Elektrocieplowni Wroclawskich KOGENERACJA had liabilities of zł1.03b due within a year, and liabilities of zł612.9m falling due after that. Offsetting these obligations, it had cash of zł5.17m as well as receivables valued at zł784.2m due within 12 months. So it has liabilities totalling zł849.5m more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the zł509.6m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Zespól Elektrocieplowni Wroclawskich KOGENERACJA would probably need a major re-capitalization if its creditors were to demand repayment.

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).

Zespól Elektrocieplowni Wroclawskich KOGENERACJA has barely any net debt, as demonstrated by its net debt to EBITDA ratio of only 0.046. Humorously, it actually received more in interest over the last twelve months than it had to pay. So there's no doubt this company can take on debt as easily as enthusiastic spray-tanners take on an orange hue. Another good sign is that Zespól Elektrocieplowni Wroclawskich KOGENERACJA has been able to increase its EBIT by 27% in twelve months, making it easier to pay down debt. 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 Zespól Elektrocieplowni Wroclawskich KOGENERACJA 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. Over the last three years, Zespól Elektrocieplowni Wroclawskich KOGENERACJA saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

While Zespól Elektrocieplowni Wroclawskich KOGENERACJA's level of total liabilities has us nervous. To wit both its interest cover and net debt to EBITDA were encouraging signs. It's also worth noting that Zespól Elektrocieplowni Wroclawskich KOGENERACJA is in the Integrated Utilities industry, which is often considered to be quite defensive. When we consider all the factors discussed, it seems to us that Zespól Elektrocieplowni Wroclawskich KOGENERACJA is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. Over time, share prices tend to follow earnings per share, so if you're interested in Zespól Elektrocieplowni Wroclawskich KOGENERACJA, you may well want to click here to check an interactive graph of its earnings per share history.

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. 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.