Is Perimeter Solutions (NYSE:PRM) Using Too Much Debt?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Perimeter Solutions, SA (NYSE:PRM) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Perimeter Solutions

What Is Perimeter Solutions's Debt?

As you can see below, Perimeter Solutions had US$777.8m of debt, at June 2024, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has US$43.2m in cash leading to net debt of about US$734.6m.

A Look At Perimeter Solutions' Liabilities

According to the last reported balance sheet, Perimeter Solutions had liabilities of US$81.9m due within 12 months, and liabilities of US$1.16b due beyond 12 months. Offsetting these obligations, it had cash of US$43.2m as well as receivables valued at US$98.5m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.10b.

This deficit is considerable relative to its market capitalization of US$1.61b, so it does suggest shareholders should keep an eye on Perimeter Solutions' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 0.69 times and a disturbingly high net debt to EBITDA ratio of 7.8 hit our confidence in Perimeter Solutions like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Even worse, Perimeter Solutions saw its EBIT tank 80% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Perimeter Solutions's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last two years, Perimeter Solutions's free cash flow amounted to 23% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

On the face of it, Perimeter Solutions's interest cover 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. And furthermore, its conversion of EBIT to free cash flow also fails to instill confidence. We're quite clear that we consider Perimeter Solutions to be really rather risky, as a result of its balance sheet health. 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. Given our concerns about Perimeter Solutions's debt levels, it seems only prudent to check if insiders have been ditching the stock.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.