Is Preformed Line Products (NASDAQ:PLPC) Using Too Much Debt?

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.' 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. We note that Preformed Line Products Company (NASDAQ:PLPC) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Preformed Line Products

What Is Preformed Line Products's Net Debt?

As you can see below, at the end of September 2020, Preformed Line Products had US$68.0m of debt, up from US$63.0m a year ago. Click the image for more detail. However, because it has a cash reserve of US$41.2m, its net debt is less, at about US$26.8m.

How Healthy Is Preformed Line Products' Balance Sheet?

According to the last reported balance sheet, Preformed Line Products had liabilities of US$98.2m due within 12 months, and liabilities of US$74.3m due beyond 12 months. Offsetting this, it had US$41.2m in cash and US$96.7m in receivables that were due within 12 months. So its liabilities total US$34.5m more than the combination of its cash and short-term receivables.

Since publicly traded Preformed Line Products shares are worth a total of US$343.0m, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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.

Preformed Line Products's net debt is only 0.47 times its EBITDA. And its EBIT covers its interest expense a whopping 21.0 times over. So we're pretty relaxed about its super-conservative use of debt. On top of that, Preformed Line Products grew its EBIT by 33% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Preformed Line Products recorded free cash flow of 27% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

The good news is that Preformed Line Products's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Zooming out, Preformed Line Products seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for Preformed Line Products you should be aware of.

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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