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 can see that Solarpack Corporacion Tecnologica, S.A. (BME:SPK) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Solarpack Corporacion Tecnologica's Net Debt?
As you can see below, at the end of March 2019, Solarpack Corporacion Tecnologica had €164.4m of debt, up from €99.8m a year ago. Click the image for more detail. However, it also had €90.2m in cash, and so its net debt is €74.2m.
How Healthy Is Solarpack Corporacion Tecnologica's Balance Sheet?
According to the last reported balance sheet, Solarpack Corporacion Tecnologica had liabilities of €32.5m due within 12 months, and liabilities of €157.4m due beyond 12 months. On the other hand, it had cash of €90.2m and €20.4m worth of receivables due within a year. So it has liabilities totalling €79.3m more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Solarpack Corporacion Tecnologica has a market capitalization of €362.5m, 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.
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).
Weak interest cover of 1.2 times and a disturbingly high net debt to EBITDA ratio of 5.3 hit our confidence in Solarpack Corporacion Tecnologica like a one-two punch to the gut. The debt burden here is substantial. On a slightly more positive note, Solarpack Corporacion Tecnologica grew its EBIT at 18% over the last year, further increasing its ability to manage debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Solarpack Corporacion Tecnologica 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 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. Over the last three years, Solarpack Corporacion Tecnologica saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, Solarpack Corporacion Tecnologica's interest cover left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Solarpack Corporacion Tecnologica's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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 Solarpack Corporacion Tecnologica's earnings per share history for free.
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.
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