Is H&R GmbH KGaA (ETR:2HRA) A Risky Investment?

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that H&R GmbH & Co. KGaA (ETR:2HRA) does use debt in its business. But the real question is whether this debt is making the company risky.

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for H&R GmbH KGaA

What Is H&R GmbH KGaA's Debt?

The image below, which you can click on for greater detail, shows that H&R GmbH KGaA had debt of €159.1m at the end of March 2021, a reduction from €175.5m over a year. However, because it has a cash reserve of €96.1m, its net debt is less, at about €63.1m.

A Look At H&R GmbH KGaA's Liabilities

The latest balance sheet data shows that H&R GmbH KGaA had liabilities of €222.4m due within a year, and liabilities of €228.9m falling due after that. Offsetting these obligations, it had cash of €96.1m as well as receivables valued at €87.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €267.7m.

This deficit is considerable relative to its market capitalization of €302.2m, so it does suggest shareholders should keep an eye on H&R GmbH KGaA's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

H&R GmbH KGaA has a very low debt to EBITDA ratio of 1.2 so it is strange to see weak interest coverage, with last year's EBIT being only 1.9 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. We also note that H&R GmbH KGaA improved its EBIT from a last year's loss to a positive €14m. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if H&R GmbH KGaA can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, H&R GmbH KGaA actually produced more free cash flow than EBIT over the last year. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

H&R GmbH KGaA's interest cover and level of total liabilities definitely weigh on it, in our esteem. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that H&R GmbH KGaA is a somewhat risky investment as a result of its debt. 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 H&R GmbH KGaA (at least 1 which is a bit concerning) , and understanding them should be part of your investment process.

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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This article by Simply Wall St is general in nature. 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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