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.' 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. Importantly, MPP Jedinstvo a.d. (BELEX:JESV) does carry debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does MPP Jedinstvo a.d Carry?
The image below, which you can click on for greater detail, shows that at September 2020 MPP Jedinstvo a.d had debt of дин1.03b, up from дин220.9m in one year. On the flip side, it has дин805.4m in cash leading to net debt of about дин224.5m.
A Look At MPP Jedinstvo a.d's Liabilities
Zooming in on the latest balance sheet data, we can see that MPP Jedinstvo a.d had liabilities of дин5.17b due within 12 months and liabilities of дин43.5m due beyond that. On the other hand, it had cash of дин805.4m and дин2.48b worth of receivables due within a year. So its liabilities total дин1.93b more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company's market capitalization of дин1.51b, we think shareholders really should watch MPP Jedinstvo a.d'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 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While MPP Jedinstvo a.d's low debt to EBITDA ratio of 0.65 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 7.0 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. The modesty of its debt load may become crucial for MPP Jedinstvo a.d if management cannot prevent a repeat of the 64% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 MPP Jedinstvo a.d will need earnings to service that debt. 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, 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. Over the last three years, MPP Jedinstvo a.d actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
On the face of it, MPP Jedinstvo a.d's level of total liabilities 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 conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that MPP Jedinstvo a.d's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 3 warning signs for MPP Jedinstvo a.d you should be aware of, and 1 of them is a bit concerning.
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.
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