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.' 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. Importantly, STINAG Stuttgart Invest AG (FRA:STG) does carry debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is STINAG Stuttgart Invest's Net Debt?
As you can see below, STINAG Stuttgart Invest had €66.9m of debt, at June 2020, which is about the same as the year before. You can click the chart for greater detail. However, it also had €24.1m in cash, and so its net debt is €42.8m.
How Strong Is STINAG Stuttgart Invest's Balance Sheet?
The latest balance sheet data shows that STINAG Stuttgart Invest had liabilities of €13.5m due within a year, and liabilities of €79.8m falling due after that. Offsetting this, it had €24.1m in cash and €1.61m in receivables that were due within 12 months. So it has liabilities totalling €67.6m more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since STINAG Stuttgart Invest has a market capitalization of €306.7m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
STINAG Stuttgart Invest has a debt to EBITDA ratio of 3.7 and its EBIT covered its interest expense 3.4 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. One redeeming factor for STINAG Stuttgart Invest is that it turned last year's EBIT loss into a gain of €6.9m, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since STINAG Stuttgart Invest will need earnings to service that debt. 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 is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, STINAG Stuttgart Invest recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.
Mulling over STINAG Stuttgart Invest's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. Having said that, its ability to handle its total liabilities isn't such a worry. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making STINAG Stuttgart Invest stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. To that end, you should learn about the 5 warning signs we've spotted with STINAG Stuttgart Invest (including 2 which is make us uncomfortable) .
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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