Is A.A.A. Allgemeine Anlageverwaltung (FRA:AAA) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, A.A.A. Aktiengesellschaft Allgemeine Anlageverwaltung (FRA:AAA) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for A.A.A. Allgemeine Anlageverwaltung

What Is A.A.A. Allgemeine Anlageverwaltung's Net Debt?

The image below, which you can click on for greater detail, shows that A.A.A. Allgemeine Anlageverwaltung had debt of €44.1m at the end of December 2020, a reduction from €53.1m over a year. And it doesn't have much cash, so its net debt is about the same.

A Look At A.A.A. Allgemeine Anlageverwaltung's Liabilities

According to the last reported balance sheet, A.A.A. Allgemeine Anlageverwaltung had liabilities of €8.84m due within 12 months, and liabilities of €43.8m due beyond 12 months. On the other hand, it had cash of €424.1k and €3.15m worth of receivables due within a year. So it has liabilities totalling €49.1m more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's €33.8m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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). 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).

A.A.A. Allgemeine Anlageverwaltung shareholders face the double whammy of a high net debt to EBITDA ratio (25.5), and fairly weak interest coverage, since EBIT is just 1.6 times the interest expense. The debt burden here is substantial. Investors should also be troubled by the fact that A.A.A. Allgemeine Anlageverwaltung saw its EBIT drop by 14% over the last twelve months. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. The balance sheet is clearly the area to focus on when you are analysing debt. But it is A.A.A. Allgemeine Anlageverwaltung's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, A.A.A. Allgemeine Anlageverwaltung actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

On the face of it, A.A.A. Allgemeine Anlageverwaltung's interest cover left us tentative about the stock, and its net debt to EBITDA was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. We're quite clear that we consider A.A.A. Allgemeine Anlageverwaltung to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 3 warning signs we've spotted with A.A.A. Allgemeine Anlageverwaltung (including 2 which 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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