Warren Buffett famously said, '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. As with many other companies Compugroup Medical SE & Co. KGaA (ETR:COP) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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.
What Is Compugroup Medical SE KGaA's Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 Compugroup Medical SE KGaA had €420.1m of debt, an increase on €367.8m, over one year. However, it does have €172.4m in cash offsetting this, leading to net debt of about €247.7m.
How Strong Is Compugroup Medical SE KGaA's Balance Sheet?
According to the last reported balance sheet, Compugroup Medical SE KGaA had liabilities of €231.1m due within 12 months, and liabilities of €562.8m due beyond 12 months. Offsetting this, it had €172.4m in cash and €155.5m in receivables that were due within 12 months. So it has liabilities totalling €466.1m more than its cash and near-term receivables, combined.
Of course, Compugroup Medical SE KGaA has a market capitalization of €3.81b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Compugroup Medical SE KGaA's net debt to EBITDA ratio of about 1.5 suggests only moderate use of debt. And its strong interest cover of 21.3 times, makes us even more comfortable. On the other hand, Compugroup Medical SE KGaA saw its EBIT drop by 3.2% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. 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 Compugroup Medical SE KGaA'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Compugroup Medical SE KGaA recorded free cash flow worth 63% 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.
Compugroup Medical SE KGaA's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its EBIT growth rate. It's also worth noting that Compugroup Medical SE KGaA is in the Healthcare Services industry, which is often considered to be quite defensive. Taking all this data into account, it seems to us that Compugroup Medical SE KGaA takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for Compugroup Medical SE KGaA that you should be aware of.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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