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Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ 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. We can see that Vereinigte Filzfabriken AG (MUN:VFF) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Vereinigte Filzfabriken’s Net Debt?
The chart below, which you can click on for greater detail, shows that Vereinigte Filzfabriken had €3.02m in debt in December 2018; about the same as the year before. However, it does have €152.5k in cash offsetting this, leading to net debt of about €2.87m.
How Strong Is Vereinigte Filzfabriken’s Balance Sheet?
The latest balance sheet data shows that Vereinigte Filzfabriken had liabilities of €5.10m due within a year, and liabilities of €2.13m falling due after that. On the other hand, it had cash of €152.5k and €1.99m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €5.09m.
While this might seem like a lot, it is not so bad since Vereinigte Filzfabriken has a market capitalization of €20.2m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution. Either way, since Vereinigte Filzfabriken does have more debt than cash, it’s worth keeping an eye on its balance sheet.
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).
Vereinigte Filzfabriken’s debt is only 2.58 times its EBITDA, and its EBIT cover its interest expense 3.30 times over. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. Shareholders should be aware that Vereinigte Filzfabriken’s EBIT was down 51% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But it is Vereinigte Filzfabriken’s earnings that will influence how the balance sheet holds up in the future. So if you’re keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Vereinigte Filzfabriken recorded free cash flow worth a fulsome 83% of its EBIT, which is stronger than we’d usually expect. That puts it in a very strong position to pay down debt.
Neither Vereinigte Filzfabriken’s ability to grow its EBIT nor its interest cover gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Vereinigte Filzfabriken is a somewhat risky investment as a result of its debt. That’s not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. Over time, share prices tend to follow earnings per share, so if you’re interested in Vereinigte Filzfabriken, you may well want to click here to check an interactive graph of its earnings per share history.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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. Thank you for reading.