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. We note that Public Joint-Stock Company PROTEK (MCX:PRTK) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company’s use of debt, we first look at cash and debt together.
What Is PROTEK’s Debt?
The image below, which you can click on for greater detail, shows that PROTEK had debt of ₽3.11b at the end of June 2019, a reduction from ₽3.68b over a year. However, its balance sheet shows it holds ₽9.50b in cash, so it actually has ₽6.38b net cash.
How Healthy Is PROTEK’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that PROTEK had liabilities of ₽81.0b due within 12 months and liabilities of ₽21.8b due beyond that. Offsetting these obligations, it had cash of ₽9.50b as well as receivables valued at ₽32.9b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₽60.4b.
When you consider that this deficiency exceeds the company’s ₽48.9b market capitalization, you might well be inclined to review the balance sheet intently. 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. Given that PROTEK has more cash than debt, we’re pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.
Also positive, PROTEK grew its EBIT by 23% in the last year, and that should make it easier to pay down debt, going forward. There’s no doubt that we learn most about debt from the balance sheet. But it is PROTEK’s earnings that will influence how the balance sheet holds up in the future. 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. PROTEK may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, PROTEK actually produced more free cash flow than EBIT. There’s nothing better than incoming cash when it comes to staying in your lenders’ good graces.
Although PROTEK’s balance sheet isn’t particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of ₽6.38b. The cherry on top was that in converted 117% of that EBIT to free cash flow, bringing in ₽10b. So we don’t have any problem with PROTEK’s use of debt. 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. For instance, we’ve identified 2 warning signs for PROTEK (1 is a bit concerning) you should be aware of.
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.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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