Is Telefónica Deutschland Holding (ETR:O2D) A Risky Investment?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Telefónica Deutschland Holding AG (ETR:O2D) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Telefónica Deutschland Holding

How Much Debt Does Telefónica Deutschland Holding Carry?

You can click the graphic below for the historical numbers, but it shows that Telefónica Deutschland Holding had €1.69b of debt in June 2022, down from €2.13b, one year before. However, it also had €427.0m in cash, and so its net debt is €1.26b.

A Look At Telefónica Deutschland Holding's Liabilities

According to the last reported balance sheet, Telefónica Deutschland Holding had liabilities of €4.06b due within 12 months, and liabilities of €6.05b due beyond 12 months. Offsetting this, it had €427.0m in cash and €1.44b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €8.25b.

Given this deficit is actually higher than the company's market capitalization of €7.72b, 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. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Telefónica Deutschland Holding has a very low debt to EBITDA ratio of 0.82 so it is strange to see weak interest coverage, with last year's EBIT being only 2.5 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. Notably, Telefónica Deutschland Holding made a loss at the EBIT level, last year, but improved that to positive EBIT of €94m in the last twelve months. 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 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, Telefónica Deutschland Holding actually produced more free cash flow than EBIT over the last year. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Telefónica Deutschland Holding's interest cover and level of total liabilities definitely weigh on it, in our esteem. But the good news is it seems to be able to convert EBIT to free cash flow with ease. We think that Telefónica Deutschland Holding's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. 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.