We Think Zespól Elektrowni Patnów-Adamów-Konin (WSE:ZEP) Is Taking Some Risk With Its Debt

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Zespól Elektrowni Patnów-Adamów-Konin S.A. (WSE:ZEP) makes use of debt. But the more important question is: how much risk is that debt creating?

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. 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. 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.

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

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

As you can see below, at the end of September 2022, Zespól Elektrowni Patnów-Adamów-Konin had zł1.09b of debt, up from zł416.6m a year ago. Click the image for more detail. However, it also had zł937.5m in cash, and so its net debt is zł148.3m.

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

According to the last reported balance sheet, Zespól Elektrowni Patnów-Adamów-Konin had liabilities of zł1.57b due within 12 months, and liabilities of zł1.23b due beyond 12 months. Offsetting these obligations, it had cash of zł937.5m as well as receivables valued at zł1.15b due within 12 months. So it has liabilities totalling zł718.6m more than its cash and near-term receivables, combined.

Zespól Elektrowni Patnów-Adamów-Konin has a market capitalization of zł1.34b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Zespól Elektrowni Patnów-Adamów-Konin's net debt is only 0.34 times its EBITDA. And its EBIT easily covers its interest expense, being 10.5 times the size. So we're pretty relaxed about its super-conservative use of debt. Although Zespól Elektrowni Patnów-Adamów-Konin made a loss at the EBIT level, last year, it was also good to see that it generated zł379m in EBIT over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Zespól Elektrowni Patnów-Adamów-Konin's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Zespól Elektrowni Patnów-Adamów-Konin burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Zespól Elektrowni Patnów-Adamów-Konin's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. In particular, its net debt to EBITDA was re-invigorating. 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 think that Zespól Elektrowni Patnów-Adamów-Konin's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Zespól Elektrowni Patnów-Adamów-Konin is showing 2 warning signs in our investment analysis , you should know about...

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.