Here's Why Telefónica Deutschland Holding (ETR:O2D) Can Manage Its Debt Responsibly

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. We can see that Telefónica Deutschland Holding AG (ETR:O2D) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Telefónica Deutschland Holding

What Is Telefónica Deutschland Holding's Debt?

The chart below, which you can click on for greater detail, shows that Telefónica Deutschland Holding had €4.90b in debt in December 2022; about the same as the year before. However, it also had €777.0m in cash, and so its net debt is €4.12b.

How Healthy Is Telefónica Deutschland Holding's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Telefónica Deutschland Holding had liabilities of €4.29b due within 12 months and liabilities of €5.93b due beyond that. Offsetting these obligations, it had cash of €777.0m as well as receivables valued at €1.38b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €8.06b.

Given this deficit is actually higher than the company's market capitalization of €7.73b, we think shareholders really should watch Telefónica Deutschland Holding's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Telefónica Deutschland Holding has a debt to EBITDA ratio of 2.7 and its EBIT covered its interest expense 6.0 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Pleasingly, Telefónica Deutschland Holding is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 353% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Telefónica Deutschland Holding's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Telefónica Deutschland Holding actually produced more free cash flow than EBIT over the last two years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Telefónica Deutschland Holding's conversion of EBIT to free cash flow was a real positive on this analysis, as was its EBIT growth rate. Having said that, its level of total liabilities somewhat sensitizes us to potential future risks to the balance sheet. When we consider all the elements mentioned above, it seems to us that Telefónica Deutschland Holding is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Telefónica Deutschland Holding 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.