David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 Preformed Line Products Company (NASDAQ:PLPC) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Preformed Line Products's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Preformed Line Products had debt of US$67.3m, up from US$41.5m in one year. However, because it has a cash reserve of US$41.3m, its net debt is less, at about US$26.1m.
How Healthy Is Preformed Line Products's Balance Sheet?
We can see from the most recent balance sheet that Preformed Line Products had liabilities of US$83.5m falling due within a year, and liabilities of US$83.8m due beyond that. Offsetting this, it had US$41.3m in cash and US$91.8m in receivables that were due within 12 months. So it has liabilities totalling US$34.3m more than its cash and near-term receivables, combined.
Of course, Preformed Line Products has a market capitalization of US$258.6m, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Preformed Line Products's net debt is only 0.63 times its EBITDA. And its EBIT covers its interest expense a whopping 30.4 times over. So we're pretty relaxed about its super-conservative use of debt. But the bad news is that Preformed Line Products has seen its EBIT plunge 16% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Preformed Line Products will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
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 three years, Preformed Line Products's free cash flow amounted to 47% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
When it comes to the balance sheet, the standout positive for Preformed Line Products was the fact that it seems able to cover its interest expense with its EBIT confidently. However, our other observations weren't so heartening. In particular, EBIT growth rate gives us cold feet. When we consider all the factors mentioned above, we do feel a bit cautious about Preformed Line Products'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. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Preformed Line Products's earnings per share history for free.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.