K+S (ETR:SDF) Has A Somewhat Strained Balance Sheet

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.' 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 K+S Aktiengesellschaft (ETR:SDF) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

View our latest analysis for K+S

How Much Debt Does K+S Carry?

You can click the graphic below for the historical numbers, but it shows that K+S had €1.66b of debt in September 2021, down from €3.26b, one year before. However, because it has a cash reserve of €1.03b, its net debt is less, at about €639.5m.

How Strong Is K+S' Balance Sheet?

We can see from the most recent balance sheet that K+S had liabilities of €1.38b falling due within a year, and liabilities of €2.45b due beyond that. Offsetting these obligations, it had cash of €1.03b as well as receivables valued at €449.1m due within 12 months. So it has liabilities totalling €2.35b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of €2.86b, so it does suggest shareholders should keep an eye on K+S' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

K+S has a low net debt to EBITDA ratio of only 0.16. And its EBIT easily covers its interest expense, being 40.8 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Although K+S made a loss at the EBIT level, last year, it was also good to see that it generated €3.6b in EBIT over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine K+S'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Considering the last year, K+S actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

We feel some trepidation about K+S's difficulty conversion of EBIT to free cash flow, but we've got positives to focus on, too. For example, its interest cover and net debt to EBITDA give us some confidence in its ability to manage its debt. Taking the abovementioned factors together we do think K+S's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for K+S that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.