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. As with many other companies Compagnie des Alpes SA (EPA:CDA) makes use of debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Compagnie des Alpes’s Debt?
As you can see below, at the end of March 2019, Compagnie des Alpes had €466.4m of debt, up from €324.1m a year ago. Click the image for more detail. However, it does have €89.7m in cash offsetting this, leading to net debt of about €376.7m.
How Strong Is Compagnie des Alpes’s Balance Sheet?
We can see from the most recent balance sheet that Compagnie des Alpes had liabilities of €570.1m falling due within a year, and liabilities of €374.5m due beyond that. Offsetting these obligations, it had cash of €89.7m as well as receivables valued at €109.5m due within 12 months. So its liabilities total €745.4m more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company’s market capitalization of €581.6m, we think shareholders really should watch Compagnie des Alpes’s debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Compagnie des Alpes’s net debt to EBITDA ratio of about 2.3 suggests only moderate use of debt. And its commanding EBIT of 12.6 times its interest expense, implies the debt load is as light as a peacock feather. Sadly, Compagnie des Alpes’s EBIT actually dropped 7.6% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. 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 Compagnie des Alpes 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. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Compagnie des Alpes recorded free cash flow of 25% of its EBIT, which is weaker than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
We’d go so far as to say Compagnie des Alpes’s level of total liabilities was disappointing. But at least it’s pretty decent at covering its interest expense with its EBIT; that’s encouraging. Looking at the bigger picture, it seems clear to us that Compagnie des Alpes’s use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. Over time, share prices tend to follow earnings per share, so if you’re interested in Compagnie des Alpes, you may well want to click here to check an interactive graph of its earnings per share history.
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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