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. 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, ERAMET S.A. (EPA:ERA) does carry debt. But is this debt a concern to shareholders?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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 ERAMET’s Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 ERAMET had debt of €2.07b, up from €1.78b in one year. However, it also had €1.14b in cash, and so its net debt is €930.0m.
How Strong Is ERAMET’s Balance Sheet?
According to the last reported balance sheet, ERAMET had liabilities of €1.37b due within 12 months, and liabilities of €2.89b due beyond 12 months. Offsetting these obligations, it had cash of €1.14b as well as receivables valued at €413.0m due within 12 months. So its liabilities total €2.71b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the €1.28b company, like a colossus towering over mere mortals. So we’d watch its balance sheet closely, without a doubt At the end of the day, ERAMET would probably need a major re-capitalization if its creditors were to demand repayment.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).
Looking at its net debt to EBITDA of 1.5 and interest cover of 3.6 times, it seems to us that ERAMET is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Importantly, ERAMET’s EBIT fell a jaw-dropping 41% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if ERAMET can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, ERAMET’s free cash flow amounted to 41% of its EBIT, less than we’d expect. That’s not great, when it comes to paying down debt.
To be frank both ERAMET’s EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its net debt to EBITDA is a good sign, and makes us more optimistic. After considering the datapoints discussed, we think ERAMET has too much debt. That sort of riskiness is ok for some, but it certainly doesn’t float our boat. While ERAMET didn’t make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away.Click here to see if its earnings are heading in the right direction, over the medium term.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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