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. We note that ENCE Energía y Celulosa, S.A. (BME:ENC) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. If things get really bad, the lenders can take control of the business. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does ENCE Energía y Celulosa Carry?
The image below, which you can click on for greater detail, shows that at June 2019 ENCE Energía y Celulosa had debt of €587.0m, up from €391.9m in one year. On the flip side, it has €201.0m in cash leading to net debt of about €385.9m.
How Strong Is ENCE Energía y Celulosa's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that ENCE Energía y Celulosa had liabilities of €323.6m due within 12 months and liabilities of €732.1m due beyond that. Offsetting this, it had €201.0m in cash and €118.3m in receivables that were due within 12 months. So it has liabilities totalling €736.4m more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of €886.7m, so it does suggest shareholders should keep an eye on ENCE Energía y Celulosa's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
We'd say that ENCE Energía y Celulosa's moderate net debt to EBITDA ratio ( being 1.7), indicates prudence when it comes to debt. And its commanding EBIT of 13.8 times its interest expense, implies the debt load is as light as a peacock feather. The bad news is that ENCE Energía y Celulosa saw its EBIT decline by 17% over the last year. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine ENCE Energía y Celulosa'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.
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, ENCE Energía y Celulosa's free cash flow amounted to 33% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
We'd go so far as to say ENCE Energía y Celulosa's EBIT growth rate was disappointing. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that ENCE Energía y Celulosa'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. Given our hesitation about the stock, it would be good to know if ENCE Energía y Celulosa insiders have sold any shares recently. You click here to find out if insiders have sold recently.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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