We Think Polenergia (WSE:PEP) Can Stay On Top Of Its Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Polenergia S.A. (WSE:PEP) does use debt in its business. But is this debt a concern to shareholders?

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. If things get really bad, the lenders can take control of the business. 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 Polenergia

What Is Polenergia's Debt?

The chart below, which you can click on for greater detail, shows that Polenergia had zł1.53b in debt in December 2023; about the same as the year before. However, it does have zł1.41b in cash offsetting this, leading to net debt of about zł121.4m.

How Strong Is Polenergia's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Polenergia had liabilities of zł904.1m due within 12 months and liabilities of zł1.81b due beyond that. Offsetting these obligations, it had cash of zł1.41b as well as receivables valued at zł584.8m due within 12 months. So it has liabilities totalling zł718.4m more than its cash and near-term receivables, combined.

Given Polenergia has a market capitalization of zł5.45b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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 has a low net debt to EBITDA ratio of only 0.22. And its EBIT covers its interest expense a whopping 10.0 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In addition to that, we're happy to report that Polenergia has boosted its EBIT by 71%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Polenergia can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Polenergia burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

The good news is that Polenergia's demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. Looking at all the aforementioned factors together, it strikes us that Polenergia can handle its debt fairly comfortably. 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. 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 2 warning signs for Polenergia you should be aware of, and 1 of them is a bit concerning.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.