Is Paul Hartmann (FRA:PHH2) A Risky Investment?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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 Paul Hartmann AG (FRA:PHH2) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Paul Hartmann

What Is Paul Hartmann's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2022 Paul Hartmann had €168.5m of debt, an increase on €10.6m, over one year. However, it does have €107.8m in cash offsetting this, leading to net debt of about €60.6m.

A Look At Paul Hartmann's Liabilities

The latest balance sheet data shows that Paul Hartmann had liabilities of €502.5m due within a year, and liabilities of €375.3m falling due after that. Offsetting this, it had €107.8m in cash and €434.5m in receivables that were due within 12 months. So it has liabilities totalling €335.5m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Paul Hartmann is worth €784.9m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Paul Hartmann's net debt is only 0.48 times its EBITDA. And its EBIT easily covers its interest expense, being 26.4 times the size. So we're pretty relaxed about its super-conservative use of debt. The modesty of its debt load may become crucial for Paul Hartmann if management cannot prevent a repeat of the 63% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Paul Hartmann 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Paul Hartmann reported free cash flow worth 18% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

While Paul Hartmann's EBIT growth rate has us nervous. To wit both its interest cover and net debt to EBITDA were encouraging signs. It's also worth noting that Paul Hartmann is in the Medical Equipment industry, which is often considered to be quite defensive. We think that Paul Hartmann's debt does make it a bit risky, after considering the aforementioned data points together. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Paul Hartmann (at least 1 which doesn't sit too well with us) , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.