These 4 Measures Indicate That MTU Aero Engines (ETR:MTX) Is Using Debt Extensively

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. As with many other companies MTU Aero Engines AG (ETR:MTX) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for MTU Aero Engines

What Is MTU Aero Engines's Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 MTU Aero Engines had €1.41b of debt, an increase on €1.07b, over one year. However, because it has a cash reserve of €811.0m, its net debt is less, at about €597.0m.

How Healthy Is MTU Aero Engines' Balance Sheet?

We can see from the most recent balance sheet that MTU Aero Engines had liabilities of €2.97b falling due within a year, and liabilities of €2.50b due beyond that. Offsetting these obligations, it had cash of €811.0m as well as receivables valued at €1.91b due within 12 months. So its liabilities total €2.75b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since MTU Aero Engines has a huge market capitalization of €10.7b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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).

MTU Aero Engines's net debt is only 1.3 times its EBITDA. And its EBIT covers its interest expense a whopping 16.5 times over. So we're pretty relaxed about its super-conservative use of debt. In fact MTU Aero Engines's saving grace is its low debt levels, because its EBIT has tanked 53% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine MTU Aero Engines's ability to maintain a healthy balance sheet going forward. 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, MTU Aero Engines recorded free cash flow worth 53% 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

Neither MTU Aero Engines's ability to grow its EBIT nor its level of total liabilities gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that MTU Aero Engines is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. Be aware that MTU Aero Engines is showing 3 warning signs in our investment analysis , you should know about...

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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