The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that ABO-Group Environment NV (EBR:ABO) does have debt on its balance sheet. 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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.
How Much Debt Does ABO-Group Environment Carry?
As you can see below, ABO-Group Environment had €14.2m of debt at June 2020, down from €20.4m a year prior. However, it does have €13.3m in cash offsetting this, leading to net debt of about €971.0k.
How Healthy Is ABO-Group Environment’s Balance Sheet?
According to the last reported balance sheet, ABO-Group Environment had liabilities of €26.6m due within 12 months, and liabilities of €10.2m due beyond 12 months. Offsetting this, it had €13.3m in cash and €15.1m in receivables that were due within 12 months. So it has liabilities totalling €8.39m more than its cash and near-term receivables, combined.
ABO-Group Environment has a market capitalization of €27.9m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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.
ABO-Group Environment’s net debt is only 0.18 times its EBITDA. And its EBIT easily covers its interest expense, being 10.3 times the size. So we’re pretty relaxed about its super-conservative use of debt. In addition to that, we’re happy to report that ABO-Group Environment has boosted its EBIT by 95%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But it is ABO-Group Environment’s earnings that will influence how the balance sheet holds up in the future. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
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. Over the last three years, ABO-Group Environment actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Happily, ABO-Group Environment’s impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And the good news does not stop there, as its EBIT growth rate also supports that impression! Overall, we don’t think ABO-Group Environment is taking any bad risks, as its debt load seems modest. So the balance sheet looks pretty healthy, to us. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that ABO-Group Environment is showing 2 warning signs in our investment analysis , you should know about…
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.
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