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.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that FRoSTA Aktiengesellschaft (FRA:NLM) does use debt in its business. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.
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How Much Debt Does FRoSTA Carry?
The image below, which you can click on for greater detail, shows that FRoSTA had debt of €38.2m at the end of June 2020, a reduction from €51.4m over a year. However, because it has a cash reserve of €19.4m, its net debt is less, at about €18.8m.
How Healthy Is FRoSTA’s Balance Sheet?
The latest balance sheet data shows that FRoSTA had liabilities of €124.7m due within a year, and liabilities of €19.6m falling due after that. Offsetting these obligations, it had cash of €19.4m as well as receivables valued at €65.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €59.9m.
Of course, FRoSTA has a market capitalization of €448.9m, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
FRoSTA has a low debt to EBITDA ratio of only 0.42. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So it’s fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. On top of that, FRoSTA grew its EBIT by 42% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is FRoSTA’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, 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, FRoSTA recorded free cash flow of 37% of its EBIT, which is weaker than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
Our View
The good news is that FRoSTA’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. Zooming out, FRoSTA seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We’ve spotted 1 warning sign for FRoSTA 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.
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