Stock Analysis

Does Deutsche Wohnen (ETR:DWNI) Have A Healthy Balance Sheet?

XTRA:DWNI
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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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Deutsche Wohnen SE (ETR:DWNI) does use debt in its business. But is this debt a concern to shareholders?

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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Deutsche Wohnen

What Is Deutsche Wohnen's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Deutsche Wohnen had €11.7b of debt, an increase on €10.1b, over one year. However, it also had €328.2m in cash, and so its net debt is €11.4b.

debt-equity-history-analysis
XTRA:DWNI Debt to Equity History December 4th 2020

How Healthy Is Deutsche Wohnen's Balance Sheet?

We can see from the most recent balance sheet that Deutsche Wohnen had liabilities of €1.38b falling due within a year, and liabilities of €15.5b due beyond that. On the other hand, it had cash of €328.2m and €199.5m worth of receivables due within a year. So it has liabilities totalling €16.3b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's huge €14.3b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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.

With a net debt to EBITDA ratio of 15.1, it's fair to say Deutsche Wohnen does have a significant amount of debt. However, its interest coverage of 4.4 is reasonably strong, which is a good sign. Fortunately, Deutsche Wohnen grew its EBIT by 5.6% in the last year, slowly shrinking its debt relative to earnings. 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 Deutsche Wohnen'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.

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. During the last three years, Deutsche Wohnen produced sturdy free cash flow equating to 68% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

We'd go so far as to say Deutsche Wohnen's net debt to EBITDA was disappointing. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Once we consider all the factors above, together, it seems to us that Deutsche Wohnen's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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 instance, we've identified 4 warning signs for Deutsche Wohnen (2 are potentially serious) you should be aware of.

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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