We Think Wodkan Przedsiebiorstwo Wodociagów i Kanalizacji (WSE:WOD) Is Taking Some Risk With Its Debt

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.' 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. As with many other companies Wodkan Przedsiebiorstwo Wodociagów i Kanalizacji S.A. (WSE:WOD) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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 examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Wodkan Przedsiebiorstwo Wodociagów i Kanalizacji

What Is Wodkan Przedsiebiorstwo Wodociagów i Kanalizacji's Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 Wodkan Przedsiebiorstwo Wodociagów i Kanalizacji had zł10.8m of debt, an increase on zł8.18m, over one year. However, it does have zł6.60m in cash offsetting this, leading to net debt of about zł4.18m.

How Strong Is Wodkan Przedsiebiorstwo Wodociagów i Kanalizacji's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Wodkan Przedsiebiorstwo Wodociagów i Kanalizacji had liabilities of zł8.11m due within 12 months and liabilities of zł54.1m due beyond that. Offsetting this, it had zł6.60m in cash and zł4.93m in receivables that were due within 12 months. So its liabilities total zł50.7m more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of zł50.2m, 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.

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).

Wodkan Przedsiebiorstwo Wodociagów i Kanalizacji has net debt of just 0.40 times EBITDA, suggesting it could ramp leverage without breaking a sweat. And remarkably, despite having net debt, 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 while staying cool as a cucumber. It is just as well that Wodkan Przedsiebiorstwo Wodociagów i Kanalizacji's load is not too heavy, because its EBIT was down 36% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Wodkan Przedsiebiorstwo Wodociagów i Kanalizacji 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

On the face of it, Wodkan Przedsiebiorstwo Wodociagów i Kanalizacji's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We should also note that Water Utilities industry companies like Wodkan Przedsiebiorstwo Wodociagów i Kanalizacji commonly do use debt without problems. Looking at the bigger picture, it seems clear to us that Wodkan Przedsiebiorstwo Wodociagów i Kanalizacji's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example - Wodkan Przedsiebiorstwo Wodociagów i Kanalizacji has 3 warning signs we think you should be aware of.

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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