These 4 Measures Indicate That Encavis (ETR:ECV) 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.' 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 note that Encavis AG (ETR:ECV) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Encavis

What Is Encavis's Net Debt?

The chart below, which you can click on for greater detail, shows that Encavis had €1.76b in debt in September 2022; about the same as the year before. However, it also had €349.2m in cash, and so its net debt is €1.41b.

A Look At Encavis' Liabilities

We can see from the most recent balance sheet that Encavis had liabilities of €319.4m falling due within a year, and liabilities of €2.03b due beyond that. Offsetting this, it had €349.2m in cash and €130.0m in receivables that were due within 12 months. So it has liabilities totalling €1.87b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of €2.62b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

Encavis's debt is 4.7 times its EBITDA, and its EBIT cover its interest expense 3.3 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. The good news is that Encavis grew its EBIT a smooth 71% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Encavis can strengthen its balance sheet over time. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Encavis actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Both Encavis'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 net debt to EBITDA had us nibbling our nails. Considering this range of data points, we think Encavis is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for Encavis you should be aware of, and 1 of them is a bit unpleasant.

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.