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Howard Marks put it well when he said that, rather than worrying about stock price volatility, “the possibility of permanent loss is the risk I worry about … and every investor practice that I know is worried. So it can be obvious that you need to consider debt, when you think about how risky a given stock is, because too much debt can sink a business. Like many other companies Precot Limited (NSE: PRECOT) uses debt. But should shareholders be concerned about its use of debt?
When is debt dangerous?
Generally speaking, debt only becomes a real problem when a company cannot repay it easily, either by raising capital or with its own cash flow. If things really go wrong, lenders can take over the business. However, a more common (but still painful) scenario is that he has to raise new equity at low cost, thereby constantly diluting shareholders. Of course, many companies use debt to finance their growth without negative consequences. When we think of a business’s use of debt, we first look at cash flow and debt together.
See our latest analysis for Precot
What is Precot’s debt?
The image below, which you can click for more details, shows that in September 2021, Precot was in debt of 2.76 billion yen, up from 2.52 billion yen in a year. However, because it has a cash reserve of 114.9 million yen, its net debt is less, at around 2.65 billion yen.
How strong is Precot’s balance sheet?
Zooming in on the latest balance sheet data, we can see that Precot had liabilities of 2.24 billion yen due within 12 months and liabilities of 1.55 billion yen due beyond. In return, he had 114.9 million yen in cash and 1.05 billion yen in receivables due within 12 months. It therefore has liabilities totaling 2.63 billion yen more than its combined cash and short-term receivables.
This is a mountain of leverage compared to its market cap of 3.72 billion yen. This suggests that shareholders would be greatly diluted if the company needed to consolidate its balance sheet quickly.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its earnings before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Precot has net debt of 1.9 times EBITDA, which isn’t too much, but its interest coverage seems a bit weak, with EBIT at just 4.4 times interest expense. While we’re not worried about these numbers, it’s worth noting that the cost of the company’s debt does have a real impact. Fortunately, Precot is increasing its EBIT faster than former Australian Prime Minister Bob Hawke, with a gain of 555% in the past twelve months. The balance sheet is clearly the area to focus on when analyzing debt. But it is Precot’s results that will influence the way the balance sheet looks in the future. So if you want to know more about its profits, it may be worth checking out this long term profit trend chart.
Finally, while the IRS may love accounting profits, lenders only accept hard cash. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Precot has generated free cash flow of a very solid 93% of its EBIT, more than we expected. This positions it well to repay debt if it is desirable.
Our point of view
The good news is that Precot’s demonstrated ability to convert EBIT into free cash flow delights us like a fluffy puppy does a toddler. But, on a darker note, we’re a little concerned with its total liability level. All these things considered, it looks like Precot can comfortably manage its current debt level. Of course, while this leverage can improve returns on equity, it comes with more risk, so it’s worth keeping an eye out for. When analyzing debt levels, the balance sheet is the obvious place to start. But at the end of the day, every business can contain risks that exist off the balance sheet. For example, we have identified 3 warning signs for Precot (1 cannot be ignored) you must be aware.
Of course, if you are the type of investor who prefers to buy stocks without going into debt, feel free to check out our exclusive list of cash net growth stocks today.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only 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 into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.
