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

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.' 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 Deutsche Wohnen SE (ETR:DWNI) makes use of debt. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Deutsche Wohnen

What Is Deutsche Wohnen's Net Debt?

As you can see below, at the end of March 2021, Deutsche Wohnen had €11.1b of debt, up from €9.98b a year ago. Click the image for more detail. Net debt is about the same, since the it doesn't have much cash.

How Healthy Is Deutsche Wohnen's Balance Sheet?

According to the last reported balance sheet, Deutsche Wohnen had liabilities of €742.3m due within 12 months, and liabilities of €15.9b due beyond 12 months. Offsetting these obligations, it had cash of €202.4m as well as receivables valued at €210.8m due within 12 months. So its liabilities total €16.3b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its very significant market capitalization of €17.7b, so it does suggest shareholders should keep an eye on Deutsche Wohnen's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Deutsche Wohnen has a rather high debt to EBITDA ratio of 14.8 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 5.1 times, suggesting it can responsibly service its obligations. Unfortunately, Deutsche Wohnen's EBIT flopped 13% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. 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 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. In the last three years, Deutsche Wohnen's free cash flow amounted to 24% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

We'd go so far as to say Deutsche Wohnen's net debt to EBITDA was disappointing. Having said that, its ability to cover its interest expense with its EBIT isn't such a worry. Overall, it seems to us that Deutsche Wohnen'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. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that Deutsche Wohnen is showing 3 warning signs in our investment analysis , and 2 of those make us uncomfortable...

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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