We Think DEMIRE Deutsche Mittelstand Real Estate (ETR:DMRE) Is Taking Some Risk With Its Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 can see that DEMIRE Deutsche Mittelstand Real Estate AG (ETR:DMRE) does use debt in its business. But the real question is whether this debt is making the company risky.

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 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. 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 DEMIRE Deutsche Mittelstand Real Estate

What Is DEMIRE Deutsche Mittelstand Real Estate's Net Debt?

As you can see below, at the end of September 2020, DEMIRE Deutsche Mittelstand Real Estate had €847.6m of debt, up from €742.4m a year ago. Click the image for more detail. However, because it has a cash reserve of €92.6m, its net debt is less, at about €755.1m.

How Strong Is DEMIRE Deutsche Mittelstand Real Estate's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that DEMIRE Deutsche Mittelstand Real Estate had liabilities of €83.5m due within 12 months and liabilities of €972.4m due beyond that. Offsetting this, it had €92.6m in cash and €26.3m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €937.0m.

The deficiency here weighs heavily on the €477.0m 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, DEMIRE Deutsche Mittelstand Real Estate would likely require a major re-capitalisation if it had to pay its creditors today.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).

With a net debt to EBITDA ratio of 11.6, it's fair to say DEMIRE Deutsche Mittelstand Real Estate does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 6.7 times, suggesting it can responsibly service its obligations. Importantly DEMIRE Deutsche Mittelstand Real Estate's EBIT was essentially flat over the last twelve months. We would prefer to see some earnings growth, because that always helps diminish debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if DEMIRE Deutsche Mittelstand Real Estate 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, DEMIRE Deutsche Mittelstand Real Estate recorded free cash flow worth 50% 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

On the face of it, DEMIRE Deutsche Mittelstand Real Estate's net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Overall, it seems to us that DEMIRE Deutsche Mittelstand Real Estate's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with DEMIRE Deutsche Mittelstand Real Estate (at least 1 which is a bit concerning) , and understanding them should be part of your investment process.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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