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Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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. Importantly, KPS AG (FRA:KSC) does carry debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.
Check out our latest analysis for KPS
What Is KPS’s Net Debt?
As you can see below, KPS had €17.2m of debt at March 2019, down from €31.4m a year prior. However, it does have €9.99m in cash offsetting this, leading to net debt of about €7.21m.
How Strong Is KPS’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that KPS had liabilities of €38.8m due within 12 months and liabilities of €28.5m due beyond that. Offsetting these obligations, it had cash of €9.99m as well as receivables valued at €45.6m due within 12 months. So its liabilities total €11.7m more than the combination of its cash and short-term receivables.
Since publicly traded KPS shares are worth a total of €274.6m, 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. Since KPS does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
KPS’s net debt is only 0.32 times its EBITDA. And its EBIT covers its interest expense a whopping 13.5 times over. So we’re pretty relaxed about its super-conservative use of debt. The good news is that KPS has increased its EBIT by 7.5% over twelve months, which should ease any concerns about debt repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine KPS’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, KPS produced sturdy free cash flow equating to 74% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Our View
The good news is that KPS’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Looking at the bigger picture, we think KPS’s use of debt seems quite reasonable and we’re not concerned about it. After all, sensible leverage can boost returns on equity. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check KPS’s dividend history, without delay!
At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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. Thank you for reading.