Does Evonik Industries (ETR:EVK) Have A Healthy Balance Sheet?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We note that Evonik Industries AG (ETR:EVK) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Evonik Industries

What Is Evonik Industries's Net Debt?

The chart below, which you can click on for greater detail, shows that Evonik Industries had €3.87b in debt in September 2019; about the same as the year before. However, because it has a cash reserve of €2.83b, its net debt is less, at about €1.04b.

How Strong Is Evonik Industries's Balance Sheet?

The latest balance sheet data shows that Evonik Industries had liabilities of €3.75b due within a year, and liabilities of €10.1b falling due after that. Offsetting these obligations, it had cash of €2.83b as well as receivables valued at €1.87b due within 12 months. So it has liabilities totalling €9.17b more than its cash and near-term receivables, combined.

This is a mountain of leverage even relative to its gargantuan market capitalization of €12.2b. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Evonik Industries has a low net debt to EBITDA ratio of only 0.45. And its EBIT easily covers its interest expense, being 11.2 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, Evonik Industries saw its EBIT drop by 2.9% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. 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 Evonik Industries 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. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Evonik Industries's free cash flow amounted to 46% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Evonik Industries's interest cover was a real positive on this analysis, as was its net debt to EBITDA. Having said that, its level of total liabilities somewhat sensitizes us to potential future risks to the balance sheet. Looking at all this data makes us feel a little cautious about Evonik Industries's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Evonik Industries's dividend history, without delay!

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.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.