The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Thrace Plastics Holding Company S.A. (ATH:PLAT) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Thrace Plastics Holding Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2022 Thrace Plastics Holding had €59.7m of debt, an increase on €52.4m, over one year. On the flip side, it has €40.0m in cash leading to net debt of about €19.6m.
A Look At Thrace Plastics Holding’s Liabilities
We can see from the most recent balance sheet that Thrace Plastics Holding had liabilities of €113.3m falling due within a year, and liabilities of €46.4m due beyond that. On the other hand, it had cash of €40.0m and €89.7m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €30.0m.
Since publicly traded Thrace Plastics Holding shares are worth a total of €177.5m, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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).
Thrace Plastics Holding’s net debt is only 0.33 times its EBITDA. And its EBIT covers its interest expense a whopping 25.2 times over. So we’re pretty relaxed about its super-conservative use of debt. It is just as well that Thrace Plastics Holding’s load is not too heavy, because its EBIT was down 58% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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 Thrace Plastics Holding’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Thrace Plastics Holding’s free cash flow amounted to 48% of its EBIT, less than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
Based on what we’ve seen Thrace Plastics Holding is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its interest cover. When we consider all the factors mentioned above, we do feel a bit cautious about Thrace Plastics Holding’s use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. Case in point: We’ve spotted 5 warning signs for Thrace Plastics Holding you should be aware of, and 2 of them are potentially serious.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.