Stock Analysis

Does Melexis (EBR:MELE) Have A Healthy Balance Sheet?

ENXTBR:MELE
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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.' 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 can see that Melexis NV (EBR:MELE) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we examine debt levels, we first consider both cash and debt levels, together.

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What Is Melexis's Net Debt?

The chart below, which you can click on for greater detail, shows that Melexis had €62.0m in debt in December 2020; about the same as the year before. However, it does have €58.9m in cash offsetting this, leading to net debt of about €3.12m.

debt-equity-history-analysis
ENXTBR:MELE Debt to Equity History February 15th 2021

How Strong Is Melexis' Balance Sheet?

We can see from the most recent balance sheet that Melexis had liabilities of €54.3m falling due within a year, and liabilities of €64.3m due beyond that. Offsetting these obligations, it had cash of €58.9m as well as receivables valued at €70.2m due within 12 months. So it actually has €10.4m more liquid assets than total liabilities.

This state of affairs indicates that Melexis' balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the €3.88b company is short on cash, but still worth keeping an eye on the balance sheet. But either way, Melexis has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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). 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).

Melexis has barely any net debt, as demonstrated by its net debt to EBITDA ratio of only 0.026. Happily, it actually managed to receive more interest than it paid, over the last year. So it's fair to say it can handle debt like an Olympic ice-skater handles a pirouette. Fortunately, Melexis grew its EBIT by 6.8% in the last year, making that debt load look even more manageable. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Melexis'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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Melexis produced sturdy free cash flow equating to 57% 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 Melexis's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its net debt to EBITDA is also very heartening. Zooming out, Melexis seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Melexis that you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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