The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 can see that Fresenius SE & Co. KGaA (FRA:FRE) does use debt in its business. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 Fresenius SE KGaA's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Fresenius SE KGaA had debt of €20.7b, up from €19.0b in one year. However, it does have €1.46b in cash offsetting this, leading to net debt of about €19.2b.
A Look At Fresenius SE KGaA's Liabilities
The latest balance sheet data shows that Fresenius SE KGaA had liabilities of €13.7b due within a year, and liabilities of €25.8b falling due after that. Offsetting these obligations, it had cash of €1.46b as well as receivables valued at €7.23b due within 12 months. So it has liabilities totalling €30.9b more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company's huge €23.8b market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner's social media. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Fresenius SE KGaA has a debt to EBITDA ratio of 3.3 and its EBIT covered its interest expense 6.8 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Fresenius SE KGaA grew its EBIT by 2.3% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to 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 Fresenius SE KGaA 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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Fresenius SE KGaA's free cash flow amounted to 40% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Mulling over Fresenius SE KGaA's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We should also note that Healthcare industry companies like Fresenius SE KGaA commonly do use debt without problems. Once we consider all the factors above, together, it seems to us that Fresenius SE KGaA's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. Over time, share prices tend to follow earnings per share, so if you're interested in Fresenius SE KGaA, you may well want to click here to check an interactive graph of its earnings per share history.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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