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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.' 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 can see that Pro-Pac Packaging Limited (ASX:PPG) does use debt in its business. 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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
See our latest analysis for Pro-Pac Packaging
What Is Pro-Pac Packaging's Debt?
As you can see below, Pro-Pac Packaging had AU$104.7m of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, it does have AU$23.6m in cash offsetting this, leading to net debt of about AU$81.2m.
How Strong Is Pro-Pac Packaging's Balance Sheet?
We can see from the most recent balance sheet that Pro-Pac Packaging had liabilities of AU$103.8m falling due within a year, and liabilities of AU$99.1m due beyond that. Offsetting these obligations, it had cash of AU$23.6m as well as receivables valued at AU$96.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$82.8m.
This is a mountain of leverage relative to its market capitalization of AU$121.7m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). 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).