Is Evonik Industries (ETR:EVK) 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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Evonik Industries AG (ETR:EVK) does use debt in its business. But the real question is whether this debt is making the company risky.

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. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Evonik Industries

How Much Debt Does Evonik Industries Carry?

The chart below, which you can click on for greater detail, shows that Evonik Industries had €3.88b in debt in March 2022; about the same as the year before. On the flip side, it has €1.22b in cash leading to net debt of about €2.66b.

A Look At Evonik Industries' Liabilities

According to the last reported balance sheet, Evonik Industries had liabilities of €5.24b due within 12 months, and liabilities of €7.58b due beyond 12 months. On the other hand, it had cash of €1.22b and €2.50b worth of receivables due within a year. So its liabilities total €9.10b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of €8.89b, we think shareholders really should watch Evonik Industries's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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.

Evonik Industries has a low net debt to EBITDA ratio of only 1.2. And its EBIT easily covers its interest expense, being 24.9 times the size. So we're pretty relaxed about its super-conservative use of debt. On top of that, Evonik Industries grew its EBIT by 54% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Evonik Industries's ability to maintain a healthy balance sheet going forward. 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 we always check how much of that EBIT is translated into free cash flow. During the last three years, Evonik Industries produced sturdy free cash flow equating to 60% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

The good news is that Evonik Industries's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But we must concede we find its level of total liabilities has the opposite effect. All these things considered, it appears that Evonik Industries can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for Evonik Industries 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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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.