Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 Perma-Fix Environmental Services, Inc. (NASDAQ:PESI) makes use of debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. 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.
What Is Perma-Fix Environmental Services's Debt?
The image below, which you can click on for greater detail, shows that at March 2021 Perma-Fix Environmental Services had debt of US$6.66m, up from US$3.21m in one year. However, because it has a cash reserve of US$713.0k, its net debt is less, at about US$5.94m.
How Strong Is Perma-Fix Environmental Services' Balance Sheet?
We can see from the most recent balance sheet that Perma-Fix Environmental Services had liabilities of US$33.5m falling due within a year, and liabilities of US$11.9m due beyond that. Offsetting these obligations, it had cash of US$713.0k as well as receivables valued at US$29.4m due within 12 months. So it has liabilities totalling US$15.3m more than its cash and near-term receivables, combined.
Since publicly traded Perma-Fix Environmental Services shares are worth a total of US$88.3m, 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.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Even though Perma-Fix Environmental Services's debt is only 2.4, its interest cover is really very low at 1.8. The main reason for this is that it has such high depreciation and amortisation. While companies often boast that these charges are non-cash, most such businesses will therefore require ongoing investment (that is not expensed.) In any case, it's safe to say the company has meaningful debt. Shareholders should be aware that Perma-Fix Environmental Services's EBIT was down 83% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is Perma-Fix Environmental Services'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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last two years, Perma-Fix Environmental Services burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
On the face of it, Perma-Fix Environmental Services's conversion of EBIT to free cash flow 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. Having said that, its ability to handle its total liabilities isn't such a worry. Overall, it seems to us that Perma-Fix Environmental Services's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example - Perma-Fix Environmental Services has 2 warning signs we think 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.
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