Is Splendid Medien (ETR:SPM) A Risky Investment?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Splendid Medien AG (ETR:SPM) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Splendid Medien

What Is Splendid Medien's Debt?

You can click the graphic below for the historical numbers, but it shows that Splendid Medien had €8.79m of debt in December 2020, down from €16.7m, one year before. However, because it has a cash reserve of €7.28m, its net debt is less, at about €1.51m.

How Strong Is Splendid Medien's Balance Sheet?

According to the last reported balance sheet, Splendid Medien had liabilities of €28.1m due within 12 months, and liabilities of €2.32m due beyond 12 months. On the other hand, it had cash of €7.28m and €10.4m worth of receivables due within a year. So it has liabilities totalling €12.7m more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of €9.59m, we think shareholders really should watch Splendid Medien'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.

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 very low debt to EBITDA ratio of 0.56 so it is strange to see weak interest coverage, with last year's EBIT being only 1.1 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. We also note that Splendid Medien improved its EBIT from a last year's loss to a positive €1.6m. When analysing debt levels, the balance sheet is the obvious place to start. But it is Splendid Medien's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Splendid Medien actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Splendid Medien's interest cover and level of total liabilities definitely weigh on it, in our esteem. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Splendid Medien is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Splendid Medien is showing 3 warning signs in our investment analysis , and 1 of those is significant...

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. 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.
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