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 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 Comet Holding AG (VTX:COTN) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Comet Holding Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Comet Holding had CHF75.6m of debt, an increase on CHF67.8, over one year. However, it also had CHF43.7m in cash, and so its net debt is CHF31.9m.
How Healthy Is Comet Holding’s Balance Sheet?
The latest balance sheet data shows that Comet Holding had liabilities of CHF107.1m due within a year, and liabilities of CHF85.0m falling due after that. Offsetting this, it had CHF43.7m in cash and CHF64.2m in receivables that were due within 12 months. So it has liabilities totalling CHF84.2m more than its cash and near-term receivables, combined.
Of course, Comet Holding has a market capitalization of CHF951.9m, 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). 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).
Comet Holding’s net debt to EBITDA ratio of about 2.1 suggests only moderate use of debt. And its commanding EBIT of 10.1 times its interest expense, implies the debt load is as light as a peacock feather. Shareholders should be aware that Comet Holding’s EBIT was down 71% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 Comet Holding 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Comet Holding’s free cash flow amounted to 22% of its EBIT, less than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
Comet Holding’s EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example its interest cover was refreshing. Taking the abovementioned factors together we do think Comet Holding’s debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we’ve discovered 2 warning signs for Comet Holding (of which 1 is major) which any shareholder or potential investor should be aware of.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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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