Is S.C. Promateris (BVB:PPL) Using Too Much Debt?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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, S.C. Promateris S.A. (BVB:PPL) does carry debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for S.C. Promateris

What Is S.C. Promateris's Debt?

The image below, which you can click on for greater detail, shows that at June 2021 S.C. Promateris had debt of RON36.8m, up from RON17.4m in one year. However, it also had RON12.0m in cash, and so its net debt is RON24.8m.

How Healthy Is S.C. Promateris' Balance Sheet?

The latest balance sheet data shows that S.C. Promateris had liabilities of RON40.9m due within a year, and liabilities of RON14.2m falling due after that. Offsetting these obligations, it had cash of RON12.0m as well as receivables valued at RON25.5m due within 12 months. So it has liabilities totalling RON17.6m more than its cash and near-term receivables, combined.

Of course, S.C. Promateris has a market capitalization of RON236.8m, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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

S.C. Promateris's net debt is only 1.2 times its EBITDA. And its EBIT covers its interest expense a whopping 13.2 times over. So we're pretty relaxed about its super-conservative use of debt. In addition to that, we're happy to report that S.C. Promateris has boosted its EBIT by 62%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But it is S.C. Promateris's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, S.C. Promateris 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

The good news is that S.C. Promateris's demonstrated ability to cover its interest expense with 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 S.C. Promateris can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. We've identified 4 warning signs with S.C. Promateris (at least 2 which are concerning) , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.