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. As with many other companies Solvay SA (EBR:SOLB) makes use of debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, 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 Solvay Carry?
The image below, which you can click on for greater detail, shows that at June 2019 Solvay had debt of €5.35b, up from €4.63b in one year. However, because it has a cash reserve of €1.38b, its net debt is less, at about €3.97b.
A Look At Solvay’s Liabilities
The latest balance sheet data shows that Solvay had liabilities of €4.78b due within a year, and liabilities of €7.96b falling due after that. Offsetting this, it had €1.38b in cash and €2.33b in receivables that were due within 12 months. So it has liabilities totalling €9.03b more than its cash and near-term receivables, combined.
This is a mountain of leverage even relative to its gargantuan market capitalization of €10.3b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Solvay’s net debt to EBITDA ratio of about 1.9 suggests only moderate use of debt. And its strong interest cover of 10.4 times, makes us even more comfortable. Notably Solvay’s EBIT was pretty flat over the last year. Ideally it can diminish its debt load by kick-starting earnings growth. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Solvay’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 business needs free cash flow to pay off debt; accounting profits just don’t cut it. So it’s worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Solvay recorded free cash flow worth 74% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Both Solvay’s ability to to convert EBIT to free cash flow and its interest cover gave us comfort that it can handle its debt. Having said that, its level of total liabilities somewhat sensitizes us to potential future risks to the balance sheet. When we consider all the factors mentioned above, we do feel a bit cautious about Solvay’s use of debt. While we appreciate debt can enhance returns on equity, we’d suggest that shareholders keep close watch on its debt levels, lest they increase. Given Solvay has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
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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