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. We note that Prysmian S.p.A. (BIT:PRY) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Prysmian's Debt?
You can click the graphic below for the historical numbers, but it shows that Prysmian had €3.23b of debt in June 2019, down from €3.88b, one year before. However, it does have €561.0m in cash offsetting this, leading to net debt of about €2.66b.
How Healthy Is Prysmian's Balance Sheet?
We can see from the most recent balance sheet that Prysmian had liabilities of €4.40b falling due within a year, and liabilities of €3.70b due beyond that. Offsetting this, it had €561.0m in cash and €2.81b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €4.73b.
This deficit is considerable relative to its market capitalization of €4.93b, so it does suggest shareholders should keep an eye on Prysmian's use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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.
Prysmian has a debt to EBITDA ratio of 3.3 and its EBIT covered its interest expense 6.2 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. It is well worth noting that Prysmian's EBIT shot up like bamboo after rain, gaining 54% in the last twelve months. That'll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Prysmian can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
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 three years, Prysmian produced sturdy free cash flow equating to 58% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
On our analysis Prysmian's EBIT growth rate should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For instance it seems like it has to struggle a bit to handle its total liabilities. When we consider all the factors mentioned above, we do feel a bit cautious about Prysmian'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. Over time, share prices tend to follow earnings per share, so if you're interested in Prysmian, you may well want to click here to check an interactive graph of its earnings per share history.
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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