We Think EDAG Engineering Group (ETR:ED4) Is Taking Some Risk With Its Debt

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. We note that EDAG Engineering Group AG (ETR:ED4) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for EDAG Engineering Group

What Is EDAG Engineering Group's Net Debt?

The image below, which you can click on for greater detail, shows that EDAG Engineering Group had debt of €131.7m at the end of September 2020, a reduction from €158.6m over a year. However, it does have €142.7m in cash offsetting this, leading to net cash of €11.0m.

How Strong Is EDAG Engineering Group's Balance Sheet?

According to the last reported balance sheet, EDAG Engineering Group had liabilities of €242.3m due within 12 months, and liabilities of €283.3m due beyond 12 months. Offsetting this, it had €142.7m in cash and €163.1m in receivables that were due within 12 months. So it has liabilities totalling €219.9m more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of €260.0m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. Despite its noteworthy liabilities, EDAG Engineering Group boasts net cash, so it's fair to say it does not have a heavy debt load!

Shareholders should be aware that EDAG Engineering Group's EBIT was down 74% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if EDAG Engineering Group 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. While EDAG Engineering Group has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Happily for any shareholders, EDAG Engineering Group actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing up

While EDAG Engineering Group does have more liabilities than liquid assets, it also has net cash of €11.0m. And it impressed us with free cash flow of €176m, being 320% of its EBIT. So although we see some areas for improvement, we're not too worried about EDAG Engineering Group's balance sheet. 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. Case in point: We've spotted 1 warning sign for EDAG Engineering Group you should be aware of.

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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This article by Simply Wall St is general in nature. 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.
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