Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is MERCK Kommanditgesellschaft auf Aktien's Net Debt?
You can click the graphic below for the historical numbers, but it shows that MERCK Kommanditgesellschaft auf Aktien had €11.6b of debt in June 2021, down from €13.6b, one year before. However, it does have €1.87b in cash offsetting this, leading to net debt of about €9.70b.
How Healthy Is MERCK Kommanditgesellschaft auf Aktien's Balance Sheet?
According to the last reported balance sheet, MERCK Kommanditgesellschaft auf Aktien had liabilities of €9.82b due within 12 months, and liabilities of €14.0b due beyond 12 months. On the other hand, it had cash of €1.87b and €4.12b worth of receivables due within a year. So its liabilities total €17.8b more than the combination of its cash and short-term receivables.
MERCK Kommanditgesellschaft auf Aktien has a very large market capitalization of €83.6b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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).
We'd say that MERCK Kommanditgesellschaft auf Aktien's moderate net debt to EBITDA ratio ( being 1.7), indicates prudence when it comes to debt. And its strong interest cover of 16.6 times, makes us even more comfortable. It is well worth noting that MERCK Kommanditgesellschaft auf Aktien's EBIT shot up like bamboo after rain, gaining 49% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if MERCK Kommanditgesellschaft auf Aktien can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, MERCK Kommanditgesellschaft auf Aktien produced sturdy free cash flow equating to 71% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Happily, MERCK Kommanditgesellschaft auf Aktien's impressive interest cover implies it has the upper hand on its debt. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Zooming out, MERCK Kommanditgesellschaft auf Aktien seems to use debt quite reasonably; and that gets the nod from us. 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. To that end, you should be aware of the 1 warning sign we've spotted with MERCK Kommanditgesellschaft auf Aktien .
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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.
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