Here's Why HeidelbergCement (ETR:HEI) Has A Meaningful Debt Burden

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 HeidelbergCement AG (ETR:HEI) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for HeidelbergCement

How Much Debt Does HeidelbergCement Carry?

The image below, which you can click on for greater detail, shows that HeidelbergCement had debt of €10.4b at the end of June 2020, a reduction from €11.1b over a year. However, it also had €2.46b in cash, and so its net debt is €7.95b.

A Look At HeidelbergCement's Liabilities

Zooming in on the latest balance sheet data, we can see that HeidelbergCement had liabilities of €6.46b due within 12 months and liabilities of €12.5b due beyond that. Offsetting this, it had €2.46b in cash and €2.95b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €13.6b.

Given this deficit is actually higher than the company's massive market capitalization of €11.7b, we think shareholders really should watch HeidelbergCement's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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).

HeidelbergCement has a debt to EBITDA ratio of 2.8 and its EBIT covered its interest expense 6.7 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. We saw HeidelbergCement grow its EBIT by 5.8% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. 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 HeidelbergCement 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, HeidelbergCement recorded free cash flow worth 72% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Neither HeidelbergCement's ability to handle its total liabilities nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. Looking at all the angles mentioned above, it does seem to us that HeidelbergCement is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 1 warning sign we've spotted with HeidelbergCement .

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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