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. 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. As with many other companies Splendid Medien AG (ETR:SPM) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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.
What Is Splendid Medien’s Net Debt?
As you can see below, Splendid Medien had €17.4m of debt at June 2019, down from €19.9m a year prior. On the flip side, it has €2.65m in cash leading to net debt of about €14.7m.
A Look At Splendid Medien’s Liabilities
We can see from the most recent balance sheet that Splendid Medien had liabilities of €33.7m falling due within a year, and liabilities of €3.72m due beyond that. Offsetting these obligations, it had cash of €2.65m as well as receivables valued at €12.5m due within 12 months. So it has liabilities totalling €22.3m more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the €7.49m 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. At the end of the day, Splendid Medien would probably need a major re-capitalization if its creditors were to demand repayment.
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). 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).
Splendid Medien has a debt to EBITDA ratio of 4.2 and its EBIT covered its interest expense 3.0 times. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. Another concern for investors might be that Splendid Medien’s EBIT fell 19% in the last year. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Splendid Medien’s earnings that will influence how the balance sheet holds up in the future. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
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. Over the last two years, Splendid Medien barely recorded positive free cash flow, in total. Some might say that’s a concern, when it comes considering how easily it would be for it to down debt.
On the face of it, Splendid Medien’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 even its net debt to EBITDA fails to inspire much confidence. Considering all the factors previously mentioned, we think that Splendid Medien really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. While Splendid Medien didn’t make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away.Click here to see if its earnings are heading in the right direction, over the medium term.
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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