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.' 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. As with many other companies Allreal Holding AG (VTX:ALLN) makes use of debt. But is this debt a concern to shareholders?
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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Allreal Holding's Debt?
As you can see below, Allreal Holding had CHF2.04b of debt, at June 2020, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has CHF48.8m in cash leading to net debt of about CHF2.00b.
A Look At Allreal Holding's Liabilities
Zooming in on the latest balance sheet data, we can see that Allreal Holding had liabilities of CHF743.0m due within 12 months and liabilities of CHF1.75b due beyond that. Offsetting this, it had CHF48.8m in cash and CHF59.9m in receivables that were due within 12 months. So it has liabilities totalling CHF2.38b more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of CHF3.14b, so it does suggest shareholders should keep an eye on Allreal Holding's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While Allreal Holding's debt to EBITDA ratio of 10.7 suggests a heavy debt load, its interest coverage of 7.1 implies it services that debt with ease. Overall we'd say it seems likely the company is carrying a fairly heavy swag of debt. We saw Allreal Holding grow its EBIT by 4.1% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. 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 Allreal Holding'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 last three years, Allreal Holding recorded free cash flow worth a fulsome 81% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
Based on what we've seen Allreal Holding is not finding it easy, given its net debt to EBITDA, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to convert EBIT to free cash flow is pretty flash. When we consider all the factors mentioned above, we do feel a bit cautious about Allreal Holding'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. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 3 warning signs we've spotted with Allreal Holding (including 2 which can't be ignored) .
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.
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