We Think Deutsche Wohnen (ETR:DWNI) Is Taking Some Risk With Its Debt

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 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 Deutsche Wohnen SE (ETR:DWNI) makes use of debt. But the more important question is: how much risk is that debt creating?

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 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Deutsche Wohnen

How Much Debt Does Deutsche Wohnen Carry?

As you can see below, Deutsche Wohnen had €8.49b of debt at December 2023, down from €8.98b a year prior. And it doesn't have much cash, so its net debt is about the same.

How Strong Is Deutsche Wohnen's Balance Sheet?

We can see from the most recent balance sheet that Deutsche Wohnen had liabilities of €793.5m falling due within a year, and liabilities of €12.4b due beyond that. Offsetting this, it had €157.1m in cash and €301.8m in receivables that were due within 12 months. So its liabilities total €12.7b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the €7.22b 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. After all, Deutsche Wohnen would likely require a major re-capitalisation if it had to pay its creditors today.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Deutsche Wohnen has a rather high debt to EBITDA ratio of 12.0 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 4.5 times, suggesting it can responsibly service its obligations. We note that Deutsche Wohnen grew its EBIT by 26% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Deutsche Wohnen can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Deutsche Wohnen 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

While Deutsche Wohnen's level of total liabilities has us nervous. To wit both its conversion of EBIT to free cash flow and EBIT growth rate were encouraging signs. When we consider all the factors discussed, it seems to us that Deutsche Wohnen is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. For example - Deutsche Wohnen has 1 warning sign we think you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.