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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Polypipe Group plc (LON:PLP) does carry debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Polypipe Group Carry?
As you can see below, at the end of December 2018, Polypipe Group had UK£211.4m of debt, up from UK£186.6m a year ago. Click the image for more detail. On the flip side, it has UK£46.2m in cash leading to net debt of about UK£165.2m.
A Look At Polypipe Group's Liabilities
We can see from the most recent balance sheet that Polypipe Group had liabilities of UK£108.7m falling due within a year, and liabilities of UK£222.1m due beyond that. Offsetting these obligations, it had cash of UK£46.2m as well as receivables valued at UK£31.5m due within 12 months. So its liabilities total UK£253.1m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Polypipe Group has a market capitalization of UK£816.9m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Polypipe Group's net debt to EBITDA ratio of about 1.8 suggests only moderate use of debt. And its strong interest cover of 11.0 times, makes us even more comfortable. Notably Polypipe Group's EBIT was pretty flat over the last year. We would prefer to see some earnings growth, because that always helps diminish 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 Polypipe Group can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Polypipe Group recorded free cash flow worth 79% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Happily, Polypipe Group's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And the good news does not stop there, as its interest cover also supports that impression! All these things considered, it appears that Polypipe Group can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. Over time, share prices tend to follow earnings per share, so if you're interested in Polypipe Group, you may well want to click here to check an interactive graph of its earnings per share history.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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