David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.’ So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. We can see that Revoil S.A. (ATH:REVOIL) does use debt in its business. But is this debt a concern to shareholders?
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. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Revoil’s Debt?
The image below, which you can click on for greater detail, shows that Revoil had debt of €40.3m at the end of December 2018, a reduction from €43.8m over a year. However, it also had €2.20m in cash, and so its net debt is €38.1m.
How Strong Is Revoil’s Balance Sheet?
We can see from the most recent balance sheet that Revoil had liabilities of €72.7m falling due within a year, and liabilities of €18.8m due beyond that. Offsetting these obligations, it had cash of €2.20m as well as receivables valued at €48.8m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €40.5m.
This deficit casts a shadow over the €17.3m 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, Revoil would probably need a major re-capitalization if its creditors were to demand repayment.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Revoil shareholders face the double whammy of a high net debt to EBITDA ratio (6.0), and fairly weak interest coverage, since EBIT is just 1.2 times the interest expense. This means we’d consider it to have a heavy debt load. However, one redeeming factor is that Revoil grew its EBIT at 16% over the last 12 months, boosting its ability to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Revoil’s earnings that will influence how the balance sheet holds up in the future. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
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. During the last three years, Revoil burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
To be frank both Revoil’s conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it’s pretty decent at growing its EBIT; that’s encouraging. Taking into account all the aforementioned factors, it looks like Revoil has too much debt. While some investors love that sort of risky play, it’s certainly not our cup of tea. Over time, share prices tend to follow earnings per share, so if you’re interested in Revoil, 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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