Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Covestro AG (ETR:1COV) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Covestro Carry?
You can click the graphic below for the historical numbers, but it shows that as of March 2021 Covestro had €2.11b of debt, an increase on €1.76b, over one year. But on the other hand it also has €2.84b in cash, leading to a €733.0m net cash position.
How Healthy Is Covestro's Balance Sheet?
We can see from the most recent balance sheet that Covestro had liabilities of €2.63b falling due within a year, and liabilities of €4.67b due beyond that. Offsetting these obligations, it had cash of €2.84b as well as receivables valued at €2.24b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €2.21b.
Covestro has a very large market capitalization of €10.5b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. Despite its noteworthy liabilities, Covestro boasts net cash, so it's fair to say it does not have a heavy debt load!
Better yet, Covestro grew its EBIT by 101% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Covestro 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Covestro 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. During the last three years, Covestro produced sturdy free cash flow equating to 74% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While Covestro does have more liabilities than liquid assets, it also has net cash of €733.0m. And it impressed us with its EBIT growth of 101% over the last year. So is Covestro's debt a risk? It doesn't seem so to us. 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. For instance, we've identified 3 warning signs for Covestro (1 is significant) you should be aware of.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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