We Think A.A.A. Allgemeine Anlageverwaltung (FRA:AAA) Is Taking Some Risk With Its 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.' 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 A.A.A. Aktiengesellschaft Allgemeine Anlageverwaltung (FRA:AAA) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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.

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

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

As you can see below, A.A.A. Allgemeine Anlageverwaltung had €43.1m of debt, at June 2021, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of €1.84m, its net debt is less, at about €41.3m.

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 €9.03m due within 12 months, and liabilities of €43.3m due beyond 12 months. Offsetting this, it had €1.84m in cash and €9.79m in receivables that were due within 12 months. So it has liabilities totalling €40.7m more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of €43.8m. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

A.A.A. Allgemeine Anlageverwaltung shareholders face the double whammy of a high net debt to EBITDA ratio (18.1), and fairly weak interest coverage, since EBIT is just 2.3 times the interest expense. The debt burden here is substantial. Fortunately, A.A.A. Allgemeine Anlageverwaltung grew its EBIT by 7.9% in the last year, slowly shrinking its debt relative to earnings. When analysing debt levels, the balance sheet is the obvious place to start. 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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, A.A.A. Allgemeine Anlageverwaltung actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

A.A.A. Allgemeine Anlageverwaltung's net debt to EBITDA and interest cover definitely weigh on it, in our esteem. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think A.A.A. Allgemeine Anlageverwaltung's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. Be aware that A.A.A. Allgemeine Anlageverwaltung is showing 4 warning signs in our investment analysis , and 2 of those are concerning...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.