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. Importantly, Strabag SE (VIE:STR) does carry debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Strabag Carry?
As you can see below, at the end of June 2019, Strabag had €1.52b of debt, up from €1.09b a year ago. Click the image for more detail. But on the other hand it also has €1.87b in cash, leading to a €350.0m net cash position.
How Strong Is Strabag’s Balance Sheet?
We can see from the most recent balance sheet that Strabag had liabilities of €5.81b falling due within a year, and liabilities of €2.46b due beyond that. On the other hand, it had cash of €1.87b and €3.60b worth of receivables due within a year. So its liabilities total €2.80b more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the €1.66b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we’d watch its balance sheet closely, without a doubt. At the end of the day, Strabag would probably need a major re-capitalization if its creditors were to demand repayment. Given that Strabag has more cash than debt, we’re pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.
On top of that, Strabag 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 future earnings, more than anything, that will determine Strabag’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Strabag 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. Over the last three years, Strabag actually produced more free cash flow than EBIT. There’s nothing better than incoming cash when it comes to staying in your lenders’ good graces.
While Strabag does have more liabilities than liquid assets, it also has net cash of €350.0m. And it impressed us with free cash flow of -€106.2m, being 132% of its EBIT. So we don’t have any problem with Strabag’s use of debt. 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. For example, we’ve discovered 4 warning signs for Strabag that you should be aware of before investing here.
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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