Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is Allreal Holding's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2021 Allreal Holding had CHF2.20b of debt, an increase on CHF2.08b, over one year. Net debt is about the same, since the it doesn't have much cash.
A Look At Allreal Holding's Liabilities
The latest balance sheet data shows that Allreal Holding had liabilities of CHF770.8m due within a year, and liabilities of CHF1.82b falling due after that. On the other hand, it had cash of CHF26.2m and CHF69.2m worth of receivables due within a year. So it has liabilities totalling CHF2.49b more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of CHF3.27b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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.
As it happens Allreal Holding has a fairly concerning net debt to EBITDA ratio of 11.3 but very strong interest coverage of 12.5. So either it has access to very cheap long term debt or that interest expense is going to grow! We saw Allreal Holding grow its EBIT by 4.6% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Allreal Holding produced sturdy free cash flow equating to 66% 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.
Allreal Holding's net debt to EBITDA was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its interest cover. Looking at all this data makes us feel a little cautious about Allreal Holding's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 4 warning signs with Allreal Holding (at least 2 which are concerning) , and understanding them should be part of your investment process.
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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.