Is MERCK Kommanditgesellschaft auf Aktien (ETR:MRK) A Risky Investment?

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. We note that MERCK Kommanditgesellschaft auf Aktien (ETR:MRK) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for MERCK Kommanditgesellschaft auf Aktien

What Is MERCK Kommanditgesellschaft auf Aktien's Debt?

You can click the graphic below for the historical numbers, but it shows that MERCK Kommanditgesellschaft auf Aktien had €10.6b of debt in September 2021, down from €13.1b, one year before. However, because it has a cash reserve of €1.67b, its net debt is less, at about €8.89b.

A Look At MERCK Kommanditgesellschaft auf Aktien's Liabilities

We can see from the most recent balance sheet that MERCK Kommanditgesellschaft auf Aktien had liabilities of €9.79b falling due within a year, and liabilities of €13.4b due beyond that. Offsetting this, it had €1.67b in cash and €4.21b in receivables that were due within 12 months. So it has liabilities totalling €17.3b more than its cash and near-term receivables, combined.

Of course, MERCK Kommanditgesellschaft auf Aktien has a titanic market capitalization of €88.3b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

MERCK Kommanditgesellschaft auf Aktien's net debt to EBITDA ratio of about 1.7 suggests only moderate use of debt. And its strong interest cover of 19.7 times, makes us even more comfortable. And we also note warmly that MERCK Kommanditgesellschaft auf Aktien grew its EBIT by 16% last year, making its debt load easier to handle. 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 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, MERCK Kommanditgesellschaft auf Aktien recorded free cash flow worth 72% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

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 that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. 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. After all, sensible leverage can boost returns on equity. 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. We've identified 1 warning sign with MERCK Kommanditgesellschaft auf Aktien , and understanding them should be part of your investment process.

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.