Polenergia (WSE:PEP) Seems To Use Debt Quite Sensibly

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. As with many other companies Polenergia S.A. (WSE:PEP) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Polenergia

What Is Polenergia's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Polenergia had zł894.0m of debt, an increase on zł797.5m, over one year. However, because it has a cash reserve of zł460.7m, its net debt is less, at about zł433.4m.

How Strong Is Polenergia's Balance Sheet?

We can see from the most recent balance sheet that Polenergia had liabilities of zł328.1m falling due within a year, and liabilities of zł1.04b due beyond that. 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.

This deficit isn't so bad because Polenergia is worth zł2.29b, and thus could probably raise enough capital to shore up 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

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 these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. 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. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Polenergia's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual 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

On our analysis Polenergia's conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For instance it seems like it has to struggle a bit to handle its total liabilities. When we consider all the elements mentioned above, it seems to us that Polenergia is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for Polenergia you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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