Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Polytec Holding AG (VIE:PYT) makes use of debt. But the more important question is: how much risk is that debt creating?
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. 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 step when considering a company's debt levels is to consider its cash and debt together.
What Is Polytec Holding's Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Polytec Holding had debt of €214.6m, up from €136.1m in one year. However, it also had €78.6m in cash, and so its net debt is €136.1m.
How Strong Is Polytec Holding's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Polytec Holding had liabilities of €167.0m due within 12 months and liabilities of €196.3m due beyond that. Offsetting these obligations, it had cash of €78.6m as well as receivables valued at €187.8m due within 12 months. So its liabilities total €96.9m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Polytec Holding has a market capitalization of €188.7m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Polytec Holding's net debt to EBITDA ratio of about 2.1 suggests only moderate use of debt. And its strong interest cover of 10.2 times, makes us even more comfortable. Importantly, Polytec Holding's EBIT fell a jaw-dropping 45% in the last twelve months. 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 ultimately the future profitability of the business will decide if Polytec Holding 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Polytec Holding created free cash flow amounting to 7.1% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.
Mulling over Polytec Holding's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Overall, we think it's fair to say that Polytec Holding has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Polytec Holding's dividend history, without delay!
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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