We Think Compagnie Plastic Omnium (EPA:POM) Is Taking Some Risk With Its Debt
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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Compagnie Plastic Omnium SA (EPA:POM) does carry debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
Check out our latest analysis for Compagnie Plastic Omnium
What Is Compagnie Plastic Omnium's Debt?
As you can see below, at the end of June 2019, Compagnie Plastic Omnium had €1.97b of debt, up from €1.68b a year ago. Click the image for more detail. However, because it has a cash reserve of €862.6m, its net debt is less, at about €1.11b.
A Look At Compagnie Plastic Omnium's Liabilities
Zooming in on the latest balance sheet data, we can see that Compagnie Plastic Omnium had liabilities of €3.33b due within 12 months and liabilities of €1.56b due beyond that. Offsetting these obligations, it had cash of €862.6m as well as receivables valued at €1.10b due within 12 months. So its liabilities total €2.92b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of €3.49b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
With net debt sitting at just 1.4 times EBITDA, Compagnie Plastic Omnium is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 7.7 times the interest expense over the last year. Unfortunately, Compagnie Plastic Omnium saw its EBIT slide 2.1% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Compagnie Plastic Omnium's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Compagnie Plastic Omnium recorded free cash flow of 31% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Our View
Both Compagnie Plastic Omnium's level of total liabilities and its conversion of EBIT to free cash flow were discouraging. But its not so bad at covering its interest expense with its EBIT. Taking the abovementioned factors together we do think Compagnie Plastic Omnium's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Compagnie Plastic Omnium's dividend history, without delay!
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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.
