These 4 Measures Indicate That Vestas Wind Systems (CPH:VWS) Is Using Debt Extensively

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. We note that Vestas Wind Systems A/S (CPH:VWS) 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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Vestas Wind Systems

What Is Vestas Wind Systems's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2022 Vestas Wind Systems had debt of €1.96b, up from €1.45b in one year. However, because it has a cash reserve of €1.92b, its net debt is less, at about €40.0m.

How Strong Is Vestas Wind Systems' Balance Sheet?

We can see from the most recent balance sheet that Vestas Wind Systems had liabilities of €13.0b falling due within a year, and liabilities of €3.20b due beyond that. Offsetting this, it had €1.92b in cash and €3.98b in receivables that were due within 12 months. So it has liabilities totalling €10.3b more than its cash and near-term receivables, combined.

Vestas Wind Systems has a very large market capitalization of €23.6b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. But either way, Vestas Wind Systems has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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).

Vestas Wind Systems has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.047 and EBIT of 19.5 times the interest expense. Indeed relative to its earnings its debt load seems light as a feather. In fact Vestas Wind Systems's saving grace is its low debt levels, because its EBIT has tanked 60% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Vestas Wind Systems 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Considering the last three years, Vestas Wind Systems actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

While Vestas Wind Systems's EBIT growth rate has us nervous. To wit both its interest cover and net debt to EBITDA were encouraging signs. Taking the abovementioned factors together we do think Vestas Wind Systems's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. Even though Vestas Wind Systems lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check out how earnings have been trending over the last few years.

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.