We Think Allreal Holding (VTX:ALLN) Is Taking Some Risk With Its Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Allreal Holding AG (VTX:ALLN) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Allreal Holding

What Is Allreal Holding's Debt?

The image below, which you can click on for greater detail, shows that Allreal Holding had debt of CHF2.61b at the end of December 2022, a reduction from CHF2.73b over a year. And it doesn't have much cash, so its net debt is about the same.

How Strong Is Allreal Holding's Balance Sheet?

The latest balance sheet data shows that Allreal Holding had liabilities of CHF1.08b due within a year, and liabilities of CHF2.02b falling due after that. Offsetting these obligations, it had cash of CHF14.1m as well as receivables valued at CHF43.7m due within 12 months. So it has liabilities totalling CHF3.04b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of CHF2.54b, we think shareholders really should watch Allreal Holding's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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).

As it happens Allreal Holding has a fairly concerning net debt to EBITDA ratio of 14.0 but very strong interest coverage of 11.0. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Importantly Allreal Holding's EBIT was essentially flat over the last twelve months. Ideally it can diminish its debt load by kick-starting earnings growth. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Allreal Holding 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 always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Allreal Holding recorded free cash flow worth 71% 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.

Our View

Allreal Holding's net debt to EBITDA was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example its interest cover was refreshing. Taking the abovementioned factors together we do think Allreal Holding's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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 1 warning sign for Allreal Holding 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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.