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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Paul Hartmann AG (FRA:PHH2) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt A Problem?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Paul Hartmann Carry?
The image below, which you can click on for greater detail, shows that Paul Hartmann had debt of €95.3m at the end of June 2021, a reduction from €107.5m over a year. However, its balance sheet shows it holds €105.7m in cash, so it actually has €10.4m net cash.
How Strong Is Paul Hartmann's Balance Sheet?
We can see from the most recent balance sheet that Paul Hartmann had liabilities of €468.6m falling due within a year, and liabilities of €286.4m due beyond that. Offsetting these obligations, it had cash of €105.7m as well as receivables valued at €394.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €255.0m.
While this might seem like a lot, it is not so bad since Paul Hartmann has a market capitalization of €1.21b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, Paul Hartmann also has more cash than debt, so we're pretty confident it can manage its debt safely.
On top of that, Paul Hartmann grew its EBIT by 42% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Paul Hartmann will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Paul Hartmann 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. Over the most recent three years, Paul Hartmann recorded free cash flow worth 60% 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.
While Paul Hartmann does have more liabilities than liquid assets, it also has net cash of €10.4m. And we liked the look of last year's 42% year-on-year EBIT growth. So we don't think Paul Hartmann's use of debt is risky. 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 1 warning sign with Paul Hartmann , and understanding them should be part of your investment process.
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.
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.
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