These 4 Measures Indicate That WODKAN Przedsiebiorstwo Wodociagów i Kanalizacji (WSE:WOD) Is Using Debt Extensively

By
Simply Wall St
Published
April 13, 2022
WSE:WOD
Source: Shutterstock

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.' 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. Importantly, WODKAN Przedsiebiorstwo Wodociagów i Kanalizacji S.A. (WSE:WOD) does carry debt. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. 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 WODKAN Przedsiebiorstwo Wodociagów i Kanalizacji

How Much Debt Does WODKAN Przedsiebiorstwo Wodociagów i Kanalizacji Carry?

As you can see below, at the end of December 2021, WODKAN Przedsiebiorstwo Wodociagów i Kanalizacji had zł19.3m of debt, up from zł10.8m a year ago. Click the image for more detail. On the flip side, it has zł9.94m in cash leading to net debt of about zł9.32m.

debt-equity-history-analysis
WSE:WOD Debt to Equity History April 13th 2022

How Healthy Is WODKAN Przedsiebiorstwo Wodociagów i Kanalizacji's Balance Sheet?

The latest balance sheet data shows that WODKAN Przedsiebiorstwo Wodociagów i Kanalizacji had liabilities of zł4.91m due within a year, and liabilities of zł74.3m falling due after that. On the other hand, it had cash of zł9.94m and zł2.29m worth of receivables due within a year. So its liabilities total zł67.0m more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of zł48.4m, we think shareholders really should watch WODKAN Przedsiebiorstwo Wodociagów i Kanalizacji's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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).

WODKAN Przedsiebiorstwo Wodociagów i Kanalizacji has a low net debt to EBITDA ratio of only 0.89. And its EBIT covers its interest expense a whopping 10.7 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the bad news is that WODKAN Przedsiebiorstwo Wodociagów i Kanalizacji has seen its EBIT plunge 12% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since WODKAN Przedsiebiorstwo Wodociagów i Kanalizacji 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, WODKAN Przedsiebiorstwo Wodociagów i Kanalizacji 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

On the face of it, WODKAN Przedsiebiorstwo Wodociagów i Kanalizacji's level of total liabilities left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. It's also worth noting that WODKAN Przedsiebiorstwo Wodociagów i Kanalizacji is in the Water Utilities industry, which is often considered to be quite defensive. Overall, it seems to us that WODKAN Przedsiebiorstwo Wodociagów i Kanalizacji's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. To that end, you should learn about the 3 warning signs we've spotted with WODKAN Przedsiebiorstwo Wodociagów i Kanalizacji (including 1 which is potentially serious) .

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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