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The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ 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. As with many other companies. thyssenkrupp AG (ETR:TKA) makes use of debt. But the more important question is: how much risk is that debt creating?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is thyssenkrupp’s Net Debt?
As you can see below, at the end of March 2019, thyssenkrupp had €7.66b of debt, up from €7.21b a year ago. Click the image for more detail. On the flip side, it has €3.38b in cash leading to net debt of about €4.28b.
A Look At thyssenkrupp’s Liabilities
We can see from the most recent balance sheet that thyssenkrupp had liabilities of €23.3b falling due within a year, and liabilities of €10.4b due beyond that. Offsetting these obligations, it had cash of €3.38b as well as receivables valued at €6.91b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €23.3b.
The deficiency here weighs heavily on the €7.00b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, thyssenkrupp would likely require a major re-capitalisation if it had to pay its creditors today. Because it carries more debt than cash, we think it’s worth watching thyssenkrupp’s balance sheet over time.
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.
thyssenkrupp shareholders face the double whammy of a high net debt to EBITDA ratio (5.10), and fairly weak interest coverage, since EBIT is just 1.19 times the interest expense. This means we’d consider it to have a heavy debt load. Worse, thyssenkrupp’s EBIT was down 66% over the last year. If earnings keep going like that over the long term, it has a snowball’s chance in hell of paying off that debt. 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 thyssenkrupp 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, thyssenkrupp saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, thyssenkrupp’s EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its interest cover also fails to instill confidence. Considering everything we’ve mentioned above, it’s fair to say that thyssenkrupp is carrying heavy debt load. If you harvest honey without a bee suit, you risk getting stung, so we’d probably stay away from this particular stock. Even though thyssenkrupp lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check outhow earnings have been trending over the last few years.
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.
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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Thank you for reading.