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 Deutsche Wohnen SE (ETR:DWNI) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.
View our latest analysis for Deutsche Wohnen
What Is Deutsche Wohnen's Net 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 does have €328.2m in cash offsetting this, leading to net debt of about €11.4b.
How Strong Is Deutsche Wohnen's Balance Sheet?
The latest balance sheet data shows that Deutsche Wohnen had liabilities of €1.38b due within a year, and liabilities of €15.5b falling due after that. Offsetting these obligations, it had cash of €328.2m as well as receivables valued at €199.5m due within 12 months. So its liabilities total €16.3b more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company's massive market capitalization of €13.1b, we think shareholders really should watch Deutsche Wohnen's debt levels, like a parent watching their child ride a bike for the first time. 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 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). 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 15.1 which suggests a meaningful debt load. However, its interest coverage of 4.4 is reasonably strong, which is a good sign. The good news is that Deutsche Wohnen improved its EBIT by 5.6% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. 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 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 always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Deutsche Wohnen recorded free cash flow worth 68% 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
Mulling over Deutsche Wohnen's attempt at managing its debt, based on its EBITDA,, we're certainly not enthusiastic. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. 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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Deutsche Wohnen is showing 4 warning signs in our investment analysis , and 2 of those shouldn't be ignored...
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.
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This article by Simply Wall St is general in nature. 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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About XTRA:DWNI
Moderate growth potential with imperfect balance sheet.
