Is Polenergia (WSE:PEP) 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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Polenergia S.A. (WSE:PEP) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Polenergia

How Much Debt Does Polenergia Carry?

As you can see below, at the end of September 2020, Polenergia had zł894.0m of debt, up from zł797.5m a year ago. Click the image for more detail. However, it also had zł460.7m in cash, and so its net debt is zł433.4m.

How Healthy Is Polenergia's Balance Sheet?

According to the last reported balance sheet, Polenergia had liabilities of zł328.1m due within 12 months, and liabilities of zł1.04b due beyond 12 months. Offsetting this, it had zł460.7m in cash and zł206.5m in receivables that were due within 12 months. So it has liabilities totalling zł701.9m more than its cash and near-term receivables, combined.

Polenergia has a market capitalization of zł3.39b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Polenergia's net debt is sitting at a very reasonable 1.6 times its EBITDA, while its EBIT covered its interest expense just 5.0 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. We saw Polenergia grow its EBIT by 8.4% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Polenergia can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Polenergia recorded free cash flow worth 65% 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

The good news is that Polenergia's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And its EBIT growth rate is good too. All these things considered, it appears that Polenergia can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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. Case in point: We've spotted 2 warning signs for Polenergia you should be aware of.

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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