These 4 Measures Indicate That Telefónica Deutschland Holding (ETR:O2D) Is Using Debt Reasonably Well

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Telefónica Deutschland Holding AG (ETR:O2D) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Telefónica Deutschland Holding

What Is Telefónica Deutschland Holding's Debt?

As you can see below, Telefónica Deutschland Holding had €1.70b of debt, at June 2023, which is about the same as the year before. You can click the chart for greater detail. However, it also had €308.0m in cash, and so its net debt is €1.39b.

A Look At Telefónica Deutschland Holding's Liabilities

According to the last reported balance sheet, Telefónica Deutschland Holding had liabilities of €4.33b due within 12 months, and liabilities of €5.61b due beyond 12 months. Offsetting these obligations, it had cash of €308.0m as well as receivables valued at €1.37b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €8.27b.

This deficit casts a shadow over the €5.38b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Telefónica Deutschland Holding would probably need a major re-capitalization if its creditors were to demand repayment.

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). 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).

While Telefónica Deutschland Holding's low debt to EBITDA ratio of 0.86 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.1 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Importantly, Telefónica Deutschland Holding grew its EBIT by 84% over the last twelve months, and that growth will make it easier to handle 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 Telefónica Deutschland Holding can strengthen its balance sheet over time. 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last two years, 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

Both Telefónica Deutschland Holding's ability to to convert EBIT to free cash flow and its EBIT growth rate gave us comfort that it can handle its debt. But truth be told its level of total liabilities had us nibbling our nails. When we consider all the factors mentioned above, we do feel a bit cautious about Telefónica Deutschland Holding's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. We've identified 4 warning signs with Telefónica Deutschland Holding (at least 1 which is a bit concerning) , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.