Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ 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. As with many other companies Preformed Line Products Company (NASDAQ:PLPC) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. 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, 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.
What Is Preformed Line Products’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Preformed Line Products had US$67.3m of debt, an increase on US$41.5m, over one year. However, it also had US$41.3m in cash, and so its net debt is US$26.1m.
A Look At Preformed Line Products’s Liabilities
We can see from the most recent balance sheet that Preformed Line Products had liabilities of US$83.5m falling due within a year, and liabilities of US$83.8m due beyond that. Offsetting this, it had US$41.3m in cash and US$91.8m in receivables that were due within 12 months. So its liabilities total US$34.3m more than the combination of its cash and short-term receivables.
Of course, Preformed Line Products has a market capitalization of US$257.8m, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Preformed Line Products’s net debt is only 0.63 times its EBITDA. And its EBIT covers its interest expense a whopping 30.4 times over. So we’re pretty relaxed about its super-conservative use of debt. But the bad news is that Preformed Line Products has seen its EBIT plunge 16% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 Preformed Line Products will need earnings to service that debt. 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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Preformed Line Products’s free cash flow amounted to 47% of its EBIT, less than we’d expect. That’s not great, when it comes to paying down debt.
When it comes to the balance sheet, the standout positive for Preformed Line Products was the fact that it seems able to cover its interest expense with its EBIT confidently. But the other factors we noted above weren’t so encouraging. In particular, EBIT growth rate gives us cold feet. When we consider all the factors mentioned above, we do feel a bit cautious about Preformed Line Products’s use of debt. While we appreciate debt can enhance returns on equity, we’d suggest that shareholders keep close watch on its debt levels, lest they increase. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you’ve also come to that realization, you’re in luck, because today you can view this interactive graph of Preformed Line Products’s earnings per share history for free.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Thank you for reading.