Telefónica Deutschland Holding (ETR:O2D) Takes On Some Risk With Its Use Of Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Telefónica Deutschland Holding

What Is Telefónica Deutschland Holding's Debt?

The image below, which you can click on for greater detail, shows that Telefónica Deutschland Holding had debt of €1.72b at the end of December 2021, a reduction from €5.13b over a year. However, it does have €1.02b in cash offsetting this, leading to net debt of about €696.0m.

How Strong 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 €6.49b due beyond that. Offsetting this, it had €1.02b in cash and €1.54b in receivables that were due within 12 months. So its liabilities total €8.22b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of €8.62b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Given net debt is only 0.44 times EBITDA, it is initially surprising to see that Telefónica Deutschland Holding's EBIT has low interest coverage of 1.0 times. 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 €58m in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. 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're focused on the future you can check out this free report showing analyst profit forecasts.

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. Over the last year, Telefónica Deutschland Holding actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

We feel some trepidation about Telefónica Deutschland Holding's difficulty interest cover, but we've got positives to focus on, too. For example, its conversion of EBIT to free cash flow and net debt to EBITDA give us some confidence in its ability to manage its debt. 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. There's no doubt that we learn most about debt from the balance sheet. 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.

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.