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. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Bayer Aktiengesellschaft (ETR:BAYN) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. 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. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Bayer’s Debt?
As you can see below, Bayer had €43.4b of debt, at September 2019, which is about the same the year before. You can click the chart for greater detail. On the flip side, it has €5.55b in cash leading to net debt of about €37.8b.
A Look At Bayer’s Liabilities
The latest balance sheet data shows that Bayer had liabilities of €26.1b due within a year, and liabilities of €58.6b falling due after that. Offsetting these obligations, it had cash of €5.55b as well as receivables valued at €14.2b due within 12 months. So its liabilities total €64.9b more than the combination of its cash and short-term receivables.
This is a mountain of leverage even relative to its gargantuan market capitalization of €65.7b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Weak interest cover of 0.36 times and a disturbingly high net debt to EBITDA ratio of 7.9 hit our confidence in Bayer like a one-two punch to the gut. This means we’d consider it to have a heavy debt load. Even worse, Bayer saw its EBIT tank 94% over the last 12 months. If earnings keep going like that over the long term, it has a snowball’s chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Bayer can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Bayer actually produced more free cash flow than EBIT over the last three years. There’s nothing better than incoming cash when it comes to staying in your lenders’ good graces.
On the face of it, Bayer’s interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. We’re quite clear that we consider Bayer to be really rather risky, as a result of its balance sheet health. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. While Bayer didn’t make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away.Click here to see if its earnings are heading in the right direction, over the medium term.
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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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. Thank you for reading.