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 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 Ubisoft Entertainment SA (EPA:UBI) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. 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. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Ubisoft Entertainment’s Debt?
The image below, which you can click on for greater detail, shows that at September 2019 Ubisoft Entertainment had debt of €1.85b, up from €1.40b in one year. However, it also had €1.63b in cash, and so its net debt is €219.1m.
A Look At Ubisoft Entertainment’s Liabilities
The latest balance sheet data shows that Ubisoft Entertainment had liabilities of €1.64b due within a year, and liabilities of €1.29b falling due after that. Offsetting this, it had €1.63b in cash and €397.2m in receivables that were due within 12 months. So it has liabilities totalling €897.2m more than its cash and near-term receivables, combined.
Since publicly traded Ubisoft Entertainment shares are worth a total of €7.98b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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.
Ubisoft Entertainment’s debt of just -21.63 times EBITDA is really very modest. And EBIT easily covered the interest expense 7.5 times over, lending force to that view. It is just as well that Ubisoft Entertainment’s load is not too heavy, because its EBIT was down 67% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Ubisoft Entertainment 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 it’s worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Ubisoft Entertainment recorded free cash flow worth 61% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Based on what we’ve seen Ubisoft Entertainment is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its net debt to EBITDA. When we consider all the elements mentioned above, it seems to us that Ubisoft Entertainment is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. To that end, you should be aware of the 1 warning sign we’ve spotted with Ubisoft Entertainment .
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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