The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. 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 Alexanderwerk Aktiengesellschaft (FRA:ALX) does have debt on its balance sheet. 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. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Alexanderwerk Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Alexanderwerk had €1.68m of debt, an increase on €1.54m, over one year. However, it does have €3.10m in cash offsetting this, leading to net cash of €1.42m.
How Strong Is Alexanderwerk’s Balance Sheet?
The latest balance sheet data shows that Alexanderwerk had liabilities of €6.19m due within a year, and liabilities of €3.57m falling due after that. Offsetting this, it had €3.10m in cash and €3.97m in receivables that were due within 12 months. So its liabilities total €2.68m more than the combination of its cash and short-term receivables.
Given Alexanderwerk has a market capitalization of €34.2m, it’s hard to believe these liabilities pose much threat. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Alexanderwerk also has more cash than debt, so we’re pretty confident it can manage its debt safely.
On top of that, Alexanderwerk grew its EBIT by 51% over the last twelve months, and that growth will make it easier to handle its debt. There’s no doubt that we learn most about debt from the balance sheet. But it is Alexanderwerk’s earnings that will influence how the balance sheet holds up in the future. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Alexanderwerk may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, Alexanderwerk’s free cash flow amounted to 33% of its EBIT, less than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
We could understand if investors are concerned about Alexanderwerk’s liabilities, but we can be reassured by the fact it has has net cash of €1.42m. And we liked the look of last year’s 51% year-on-year EBIT growth. So is Alexanderwerk’s debt a risk? It doesn’t seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We’ve identified 3 warning signs with Alexanderwerk (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.
At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.
If you spot an error that warrants correction, please contact the editor at email@example.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.
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