These 4 Measures Indicate That freenet (ETR:FNTN) Is Using Debt Reasonably Well

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. As with many other companies freenet AG (ETR:FNTN) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for freenet

How Much Debt Does freenet Carry?

You can click the graphic below for the historical numbers, but it shows that freenet had €602.3m of debt in September 2022, down from €678.6m, one year before. On the flip side, it has €157.3m in cash leading to net debt of about €445.0m.

How Healthy Is freenet's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that freenet had liabilities of €1.13b due within 12 months and liabilities of €1.10b due beyond that. Offsetting this, it had €157.3m in cash and €452.6m in receivables that were due within 12 months. So its liabilities total €1.62b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since freenet has a market capitalization of €2.87b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

freenet has a low net debt to EBITDA ratio of only 1.3. And its EBIT easily covers its interest expense, being 11.2 times the size. So we're pretty relaxed about its super-conservative use of debt. But the bad news is that freenet has seen its EBIT plunge 15% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine freenet's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, freenet 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

freenet's conversion of EBIT to free cash flow was a real positive on this analysis, as was its interest cover. In contrast, our confidence was undermined by its apparent struggle to grow its EBIT. Looking at all this data makes us feel a little cautious about freenet's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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 freenet is showing 4 warning signs in our investment analysis , you should know about...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.