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.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Schneider Electric S.E. (EPA:SU) makes use of debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Schneider Electric Carry?
The image below, which you can click on for greater detail, shows that Schneider Electric had debt of €8.58b at the end of June 2019, a reduction from €9.31b over a year. However, it does have €2.53b in cash offsetting this, leading to net debt of about €6.05b.
A Look At Schneider Electric’s Liabilities
According to the last reported balance sheet, Schneider Electric had liabilities of €10.7b due within 12 months, and liabilities of €11.7b due beyond 12 months. On the other hand, it had cash of €2.53b and €7.99b worth of receivables due within a year. So its liabilities total €11.9b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Schneider Electric has a huge market capitalization of €39.9b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Schneider Electric has a low net debt to EBITDA ratio of only 1.3. And its EBIT covers its interest expense a whopping 23.6 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The good news is that Schneider Electric has increased its EBIT by 7.3% over twelve months, which should ease any concerns about debt repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Schneider Electric can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Schneider Electric recorded free cash flow worth 63% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Happily, Schneider Electric’s impressive interest cover implies it has the upper hand on its debt. And that’s just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Looking at all the aforementioned factors together, it strikes us that Schneider Electric can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it’s worth monitoring the balance sheet. Given Schneider Electric has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
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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