Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, Emmi AG (VTX:EMMN) does carry debt. But the more important question is: how much risk is that debt creating?
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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
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What Is Emmi's Debt?
The image below, which you can click on for greater detail, shows that Emmi had debt of CHF460.9m at the end of June 2021, a reduction from CHF492.6m over a year. However, it does have CHF251.4m in cash offsetting this, leading to net debt of about CHF209.5m.
A Look At Emmi's Liabilities
We can see from the most recent balance sheet that Emmi had liabilities of CHF602.4m falling due within a year, and liabilities of CHF510.0m due beyond that. Offsetting this, it had CHF251.4m in cash and CHF502.8m in receivables that were due within 12 months. So it has liabilities totalling CHF358.3m more than its cash and near-term receivables, combined.
Of course, Emmi has a market capitalization of CHF5.41b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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). 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).
Emmi has a low net debt to EBITDA ratio of only 0.48. And its EBIT easily covers its interest expense, being 73.5 times the size. So we're pretty relaxed about its super-conservative use of debt. Another good sign is that Emmi has been able to increase its EBIT by 20% in twelve months, making it easier to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Emmi can strengthen its balance sheet over time. 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. Over the most recent three years, Emmi recorded free cash flow worth 73% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Our View
Emmi's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Considering this range of factors, it seems to us that Emmi is quite prudent with its debt, and the risks seem well managed. So we're not worried about the use of a little leverage on the balance sheet. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Emmi's earnings per share history for free.
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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About SWX:EMMN
Emmi
Develops, produces, and markets a range of dairy and fresh products primarily in Switzerland, the rest of Europe, North and South America, Africa, and Asia/Pacific.
Excellent balance sheet established dividend payer.