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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.’ 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 Recticel SA/NV (EBR:REC) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Recticel’s Debt?
You can click the graphic below for the historical numbers, but it shows that Recticel had €124.7m of debt in December 2018, down from €145.1m, one year before On the flip side, it has €39.7m in cash leading to net debt of about €85.0m.
How Strong Is Recticel’s Balance Sheet?
The latest balance sheet data shows that Recticel had liabilities of €341.1m due within a year, and liabilities of €131.0m falling due after that. On the other hand, it had cash of €39.7m and €170.4m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €262.0m.
This deficit is considerable relative to its market capitalization of €422.7m, so it does suggest shareholders should keep an eye on Recticel’s use of debt. So should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. Since Recticel does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, 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.
Recticel has a low net debt to EBITDA ratio of only 1.06. And its EBIT easily covers its interest expense, being 19.5 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, Recticel saw its EBIT drop by 2.4% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Recticel can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Recticel reported free cash flow worth 14% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
Recticel’s conversion of EBIT to free cash flow and level of total liabilities definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. We think that Recticel’s debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Recticel’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 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.