Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about. 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 note that Peet Limited (ASX:PPC) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Peet

How Much Debt Does Peet Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2019 Peet had AU$257.1m of debt, an increase on AU$241.1m, over one year. However, because it has a cash reserve of AU$33.6m, its net debt is less, at about AU$223.5m.

How Healthy Is Peet's Balance Sheet?

We can see from the most recent balance sheet that Peet had liabilities of AU$92.3m falling due within a year, and liabilities of AU$269.8m due beyond that. Offsetting these obligations, it had cash of AU$33.6m as well as receivables valued at AU$25.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$303.3m.

While this might seem like a lot, it is not so bad since Peet has a market capitalization of AU$575.1m, 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.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Peet has a debt to EBITDA ratio of 3.7 and its EBIT covered its interest expense 6.9 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Unfortunately, Peet saw its EBIT slide 8.1% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Peet can strengthen its balance sheet over time. 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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Peet produced sturdy free cash flow equating to 58% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

While Peet's EBIT growth rate makes us cautious about it, its track record of managing its debt, based on its EBITDA, is no better. At least its conversion of EBIT to free cash flow gives us reason to be optimistic. We think that Peet's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Peet's dividend history, without delay!

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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.