These 4 Measures Indicate That Zespól Elektrowni Patnów-Adamów-Konin (WSE:ZEP) Is Using Debt Extensively

Warren Buffett famously said, '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. We note that Zespól Elektrowni Patnów-Adamów-Konin S.A. (WSE:ZEP) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Zespól Elektrowni Patnów-Adamów-Konin

What Is Zespól Elektrowni Patnów-Adamów-Konin's Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2022 Zespól Elektrowni Patnów-Adamów-Konin had zł603.0m of debt, an increase on zł151.3m, over one year. On the flip side, it has zł321.9m in cash leading to net debt of about zł281.1m.

How Strong Is Zespól Elektrowni Patnów-Adamów-Konin's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Zespól Elektrowni Patnów-Adamów-Konin had liabilities of zł2.20b due within 12 months and liabilities of zł958.7m due beyond that. Offsetting this, it had zł321.9m in cash and zł632.8m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by zł2.21b.

Given this deficit is actually higher than the company's market capitalization of zł1.70b, we think shareholders really should watch Zespól Elektrowni Patnów-Adamów-Konin's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Zespól Elektrowni Patnów-Adamów-Konin's net debt of 1.9 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 7.1 times its interest expenses harmonizes with that theme. We also note that Zespól Elektrowni Patnów-Adamów-Konin improved its EBIT from a last year's loss to a positive zł36m. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Zespól Elektrowni Patnów-Adamów-Konin 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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Zespól Elektrowni Patnów-Adamów-Konin 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, Zespól Elektrowni Patnów-Adamów-Konin'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 on the bright side, its interest cover is a good sign, and makes us more optimistic. It's also worth noting that Zespól Elektrowni Patnów-Adamów-Konin is in the Electric Utilities industry, which is often considered to be quite defensive. We're quite clear that we consider Zespól Elektrowni Patnów-Adamów-Konin to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For example, we've discovered 1 warning sign for Zespól Elektrowni Patnów-Adamów-Konin that you should be aware of before investing here.

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.