Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. Importantly, Preformed Line Products Company (NASDAQ:PLPC) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 examine debt levels, we first consider both cash and debt levels, together.

What Is Preformed Line Products's Debt?

The image below, which you can click on for greater detail, shows that Preformed Line Products had debt of US$56.5m at the end of March 2024, a reduction from US$85.2m over a year. However, because it has a cash reserve of US$45.9m, its net debt is less, at about US$10.6m.

A Look At Preformed Line Products' Liabilities

According to the last reported balance sheet, Preformed Line Products had liabilities of US$99.7m due within 12 months, and liabilities of US$73.0m due beyond 12 months. Offsetting these obligations, it had cash of US$45.9m as well as receivables valued at US$111.5m due within 12 months. So its liabilities total US$15.4m more than the combination of its cash and short-term receivables.

Given Preformed Line Products has a market capitalization of US$614.3m, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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).

Preformed Line Products's net debt is only 0.12 times its EBITDA. And its EBIT easily covers its interest expense, being 63.0 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The modesty of its debt load may become crucial for Preformed Line Products if management cannot prevent a repeat of the 28% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Preformed Line Products will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Preformed Line Products's free cash flow amounted to 31% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Based on what we've seen Preformed Line Products is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. When we consider all the factors mentioned above, we do feel a bit cautious about Preformed Line Products's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. Over time, share prices tend to follow earnings per share, so if you're interested in Preformed Line Products, you may well want to click here to check an interactive graph of its earnings per share history.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com