These 4 Measures Indicate That Elma Electronic (VTX:ELMN) Is Using Debt Reasonably Well

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Elma Electronic AG (VTX:ELMN) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Elma Electronic

What Is Elma Electronic's Debt?

You can click the graphic below for the historical numbers, but it shows that Elma Electronic had CHF27.5m of debt in December 2020, down from CHF31.2m, one year before. On the flip side, it has CHF10.6m in cash leading to net debt of about CHF16.9m.

How Strong Is Elma Electronic's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Elma Electronic had liabilities of CHF27.4m due within 12 months and liabilities of CHF21.8m due beyond that. Offsetting these obligations, it had cash of CHF10.6m as well as receivables valued at CHF21.5m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CHF17.1m.

Since publicly traded Elma Electronic shares are worth a total of CHF123.4m, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).

Elma Electronic's net debt to EBITDA ratio of about 1.7 suggests only moderate use of debt. And its commanding EBIT of 13.2 times its interest expense, implies the debt load is as light as a peacock feather. The good news is that Elma Electronic has increased its EBIT by 4.8% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Elma Electronic will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Elma Electronic's free cash flow amounted to 25% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

On our analysis Elma Electronic's interest cover should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For example, its conversion of EBIT to free cash flow makes us a little nervous about its debt. When we consider all the elements mentioned above, it seems to us that Elma Electronic is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 1 warning sign for Elma Electronic that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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