Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital”. So it seems like smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess the level of risk of a business. We notice that Prada SpA (HKG: 1913) has debt on its balance sheet. But does this debt worry shareholders?
Why Does Debt Bring Risk?
Debts and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. If things really go wrong, lenders can take over the business. However, a more common (but still costly) situation is where a company has to dilute its shareholders at a cheap share price just to get its debt under control. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash flow and debt together.
See our latest review for Prada
What is Prada’s net debt?
As you can see below, Prada had â¬ 754.9 million in debt in December 2020, up from â¬ 829.0 million the year before. On the other hand, it has 448.6 million euros in cash, leading to a net debt of around 306.3 million euros.
A look at Prada’s responsibilities
Zooming in on the latest balance sheet data, we can see that Prada had liabilities of â¬ 1.23 billion due within 12 months and liabilities of â¬ 2.45 billion due beyond. In compensation for these commitments, he had cash of â¬ 448.6 million as well as receivables valued at â¬ 420.1 million within 12 months. Its liabilities thus exceed the sum of its cash and its (short-term) receivables by 2.81 billion euros.
Of course, Prada has a titanic market cap of 15.6 billion euros, so this liability is probably manageable. Having said that, it is clear that we must continue to monitor his record lest it get worse.
We measure a company’s debt load relative to its earning capacity by looking at its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT) covers its interest costs (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Looking at its net debt over EBITDA of 0.94 and interest coverage of 2.7 times, it seems to us that Prada is probably using the debt in a fairly reasonable way. We therefore recommend that you keep a close eye on the impact of financing costs on the business. It is important to note that Prada’s EBIT has fallen 55% over the past twelve months. If this profit trend continues, paying off debt will be about as easy as driving cats on a roller coaster. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the future profitability of the business will decide whether Prada can strengthen its balance sheet over time. So if you are focused on the future you can check this out free report showing analysts‘ earnings forecasts.
But our last consideration is also important, because a business cannot pay its debts with paper profits; he needs hard cash. It is therefore worth checking to what extent this EBIT is supported by free cash flow. Fortunately for all shareholders, Prada has actually generated more free cash flow than EBIT over the past three years. There is nothing better than cash flow to stay in the good graces of your lenders.
Our point of view
Prada’s EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled by its conversion of EBIT into free cash flow. When we consider all of the factors mentioned above, we feel a little cautious about Prada’s use of debt. While we understand that debt can improve returns on equity, we suggest shareholders watch their debt level closely, lest they increase. Even though Prada has lost money on the bottom line, its positive EBIT suggests that the company itself has potential. You may want to check the evolution of income over the past few years.
If, after all of this, you’re more interested in a fast-growing company with a strong balance sheet, take a quick look at our list of cash net growth stocks.
If you are looking for stocks to buy, use the cheapest platform * which is ranked # 1 overall by Barron’s, Interactive Brokers. Trade stocks, options, futures, currencies, bonds and funds in 135 markets, all from one integrated account.
This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares 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 the mentioned stocks.
*Interactive Brokers Ranked Least Expensive Broker By StockBrokers.com Online Annual Review 2020
Do you have any feedback on this item? Are you worried about the content? Get in touch with us directly. You can also send an email to the editorial team (at) simplywallst.com.