Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk. 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. As with many other companies Uniper SE (ETR:UN01) makes use of debt. But the real question is whether this debt is making the company risky.
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Uniper’s Net Debt?
The image below, which you can click on for greater detail, shows that Uniper had debt of €2.36b at the end of September 2019, a reduction from €3.58b over a year. However, it also had €338.0m in cash, and so its net debt is €2.02b.
How Strong Is Uniper’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Uniper had liabilities of €16.0b due within 12 months and liabilities of €12.5b due beyond that. Offsetting these obligations, it had cash of €338.0m as well as receivables valued at €14.4b due within 12 months. So it has liabilities totalling €13.7b more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company’s huge €10.7b market capitalization, you might well be inclined to review the balance sheet intently. 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).
Looking at its net debt to EBITDA of 0.72 and interest cover of 6.3 times, it seems to us that Uniper is probably using debt in a pretty reasonable way. So we’d recommend keeping a close eye on the impact financing costs are having on the business. Although Uniper made a loss at the EBIT level, last year, it was also good to see that it generated €2.2b in EBIT over 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 Uniper’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 it’s worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Uniper reported free cash flow worth 9.9% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
On the face of it, Uniper’s conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it’s pretty decent at managing its debt, based on its EBITDA,; that’s encouraging. Overall, we think it’s fair to say that Uniper has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. Given Uniper has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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