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 note that Deutsche Telekom AG (ETR:DTE) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
Our analysis indicates that DTE is potentially undervalued!
How Much Debt Does Deutsche Telekom Carry?
As you can see below, at the end of June 2022, Deutsche Telekom had €114.5b of debt, up from €109.7b a year ago. Click the image for more detail. On the flip side, it has €5.28b in cash leading to net debt of about €109.2b.
How Healthy Is Deutsche Telekom's Balance Sheet?
The latest balance sheet data shows that Deutsche Telekom had liabilities of €39.6b due within a year, and liabilities of €173.5b falling due after that. Offsetting this, it had €5.28b in cash and €19.1b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €188.8b.
The deficiency here weighs heavily on the €97.5b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Deutsche Telekom would likely require a major re-capitalisation if it had to pay its creditors today.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Deutsche Telekom's debt is 3.4 times its EBITDA, and its EBIT cover its interest expense 2.9 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Even more troubling is the fact that Deutsche Telekom actually let its EBIT decrease by 9.6% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Deutsche Telekom 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Deutsche Telekom produced sturdy free cash flow equating to 54% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Our View
Mulling over Deutsche Telekom's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, it seems to us that Deutsche Telekom'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. 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. For example Deutsche Telekom has 3 warning signs (and 1 which doesn't sit too well with us) we think you should know about.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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.
About XTRA:DTE
Established dividend payer with adequate balance sheet.
