Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. 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. Importantly, Adler Modemärkte AG (ETR:ADD) does carry debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 examine debt levels, we first consider both cash and debt levels, together.
See our latest analysis for Adler Modemärkte
What Is Adler Modemärkte’s Net Debt?
The image below, which you can click on for greater detail, shows that Adler Modemärkte had debt of €2.03m at the end of September 2019, a reduction from €5.69m over a year. However, its balance sheet shows it holds €46.4m in cash, so it actually has €44.4m net cash.
How Strong Is Adler Modemärkte’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Adler Modemärkte had liabilities of €107.5m due within 12 months and liabilities of €238.2m due beyond that. On the other hand, it had cash of €46.4m and €11.4m worth of receivables due within a year. So it has liabilities totalling €287.9m more than its cash and near-term receivables, combined.
This deficit casts a shadow over the €74.2m company, like a colossus towering over mere mortals. So we’d watch its balance sheet closely, without a doubt. After all, Adler Modemärkte would likely require a major re-capitalisation if it had to pay its creditors today. Given that Adler Modemärkte 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.
Unfortunately, Adler Modemärkte’s EBIT flopped 11% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. 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 Adler Modemärkte 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, a company can only pay off debt with cold hard cash, not accounting profits. Adler Modemärkte 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. Happily for any shareholders, Adler Modemärkte actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Summing up
While Adler Modemärkte does have more liabilities than liquid assets, it also has net cash of €44.4m. And it impressed us with free cash flow of €10m, being 162% of its EBIT. Despite the cash, we do find Adler Modemärkte’s level of total liabilities concerning, so we’re not particularly comfortable with the stock. 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. Take risks, for example – Adler Modemärkte has 2 warning signs we think you should be aware of.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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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