Does MERCK Kommanditgesellschaft auf Aktien (ETR:MRK) Have A Healthy Balance Sheet?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies MERCK Kommanditgesellschaft auf Aktien (ETR:MRK) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for MERCK Kommanditgesellschaft auf Aktien

What Is MERCK Kommanditgesellschaft auf Aktien's Debt?

The image below, which you can click on for greater detail, shows that MERCK Kommanditgesellschaft auf Aktien had debt of €10.2b at the end of March 2022, a reduction from €11.9b over a year. On the flip side, it has €1.45b in cash leading to net debt of about €8.73b.

How Strong Is MERCK Kommanditgesellschaft auf Aktien's Balance Sheet?

The latest balance sheet data shows that MERCK Kommanditgesellschaft auf Aktien had liabilities of €10.2b due within a year, and liabilities of €13.0b falling due after that. Offsetting this, it had €1.45b in cash and €4.71b in receivables that were due within 12 months. So it has liabilities totalling €17.1b more than its cash and near-term receivables, combined.

This deficit isn't so bad because MERCK Kommanditgesellschaft auf Aktien is worth a massive €70.0b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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

MERCK Kommanditgesellschaft auf Aktien's net debt is only 1.5 times its EBITDA. And its EBIT covers its interest expense a whopping 26.1 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, MERCK Kommanditgesellschaft auf Aktien grew its EBIT by 32% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine MERCK Kommanditgesellschaft auf Aktien'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, MERCK Kommanditgesellschaft auf Aktien produced sturdy free cash flow equating to 67% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

MERCK Kommanditgesellschaft auf Aktien's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And the good news does not stop there, as its EBIT growth rate also supports that impression! Looking at the bigger picture, we think MERCK Kommanditgesellschaft auf Aktien's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. Over time, share prices tend to follow earnings per share, so if you're interested in MERCK Kommanditgesellschaft auf Aktien, you may well want to click here to check an interactive graph of its earnings per share history.

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. 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.