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 Paperpack A.B.E.E. (ATH:PPAK) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for PaperpackE.E

What Is PaperpackE.E's Net Debt?

As you can see below, PaperpackE.E had €4.68m of debt at March 2019, down from €8.78m a year prior. However, it also had €1.80m in cash, and so its net debt is €2.89m.

A Look At PaperpackE.E's Liabilities

According to the last reported balance sheet, PaperpackE.E had liabilities of €6.29m due within 12 months, and liabilities of €7.83m due beyond 12 months. Offsetting this, it had €1.80m in cash and €5.47m in receivables that were due within 12 months. So it has liabilities totalling €6.85m more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since PaperpackE.E has a market capitalization of €14.5m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). 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).

Looking at its net debt to EBITDA of 0.98 and interest cover of 6.7 times, it seems to us that PaperpackE.E is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. While PaperpackE.E doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. When analysing debt levels, the balance sheet is the obvious place to start. But it is PaperpackE.E's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Considering the last three years, PaperpackE.E actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

PaperpackE.E's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability handle its debt, based on its EBITDA, isn't too shabby at all. Taking the abovementioned factors together we do think PaperpackE.E's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. Given PaperpackE.E has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.

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.