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. 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 MVV Energie AG (ETR:MVV1) does use debt in its business. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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 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. 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 MVV Energie’s Debt?
The image below, which you can click on for greater detail, shows that at September 2019 MVV Energie had debt of €1.56b, up from €1.34b in one year. On the flip side, it has €365.5m in cash leading to net debt of about €1.20b.
How Strong Is MVV Energie’s Balance Sheet?
We can see from the most recent balance sheet that MVV Energie had liabilities of €1.18b falling due within a year, and liabilities of €2.11b due beyond that. Offsetting this, it had €365.5m in cash and €513.1m in receivables that were due within 12 months. So it has liabilities totalling €2.41b more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company’s €1.82b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
MVV Energie’s debt is 3.9 times its EBITDA, and its EBIT cover its interest expense 3.1 times over. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. Worse, MVV Energie’s EBIT was down 47% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since MVV Energie will need earnings to service that debt. 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 business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, MVV Energie recorded free cash flow worth 53% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
To be frank both MVV Energie’s level of total liabilities and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it’s pretty decent at converting EBIT to free cash flow; that’s encouraging. We should also note that Integrated Utilities industry companies like MVV Energie commonly do use debt without problems. We’re quite clear that we consider MVV Energie to be really rather risky, as a result of its balance sheet health. So we’re almost as wary of this stock as a hungry kitten is about falling into its owner’s fish pond: once bitten, twice shy, as they say. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it. Take risks, for example – MVV Energie has 4 warning signs (and 2 which make us uncomfortable) we think you should know about.
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 firstname.lastname@example.org. 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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