David Iben put it well when he said, âVolatility is not a risk we care about. What matters to us is to avoid the permanent loss of capital. ‘ So it can be obvious that you need to consider debt, when you think about how risky a given stock is because too much debt can sink a business. Above all, Protektor SA (WSE: PRT) carries debt. But does this debt worry shareholders?
Why Does Debt Bring Risk?
Debts and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a business can go bankrupt if it cannot pay its creditors. However, a more common (but still costly) situation is where a company has to dilute its shareholders at a cheap share price just to get its debt under control. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution of a business with the ability to reinvest at high rates of return. When we look at debt levels, we first consider both liquidity and debt levels.
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What is Protektor’s debt?
As you can see below, at the end of September 2021, Protektor had a debt of Z17.1million, up from Z11.4million a year ago. Click on the image for more details. On the other hand, he has z3.63million in cash, resulting in net debt of around z13.5million.
How strong is Protektor’s balance sheet?
The latest balance sheet data shows that Protektor had Z41.9million debts due within one year, and Z12.5million debts due thereafter. On the other hand, he had cash of 3.63 million z and 14.3 million z in receivables due within one year. Thus, its liabilities exceed the sum of its cash and (short-term) receivables by z36.5 million.
This is a mountain of leverage compared to its market cap of z50.8million. This suggests that shareholders would be greatly diluted if the company needed to consolidate its balance sheet quickly.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its earnings before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). Thus, we look at debt versus earnings with and without amortization expenses.
While Protektor’s low debt-to-EBITDA ratio of 1.3 suggests modest use of debt, the fact that EBIT only covered interest expense 3.5 times last year gives us pause. We therefore recommend that you keep a close eye on the impact of financing costs on the business. Notably, Protektor’s EBIT was higher than Elon Musk’s, gaining a whopping 133% from last year. The balance sheet is clearly the area to focus on when analyzing debt. But you can’t look at debt in isolation; since Protektor will need income to repay this debt. So, when considering debt, it is really worth looking at the profit trend. Click here for an interactive snapshot.
Finally, a business can only pay off its debts with hard cash, not with book profits. The logical step is therefore to examine the proportion of this EBIT that corresponds to the actual free cash flow. Over the past three years, Protektor has recorded free cash flow of 98% of its EBIT, which is higher than what we usually expected. This positions it well to repay debt if it is desirable.
Our point of view
Fortunately, Protektor’s impressive conversion of EBIT to free cash flow means that it has the upper hand over its debt. But, on a darker note, we’re a little concerned about its coverage of interest. All these things considered, it looks like Protektor can comfortably manage its current debt levels. Of course, while this leverage can improve returns on equity, it comes with more risk, so it’s worth keeping an eye out for. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks lie on the balance sheet – far from it. For example, we discovered 4 warning signs for Protektor (1 is a bit nasty!) Which you should be aware of before investing here.
At the end of the day, sometimes it’s easier to focus on businesses that don’t even need to go into debt. Readers can access a list of growth stocks with zero net debt 100% free, at present.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only 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 into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.