Warren Buffett famously said, '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 Brødrene Hartmann A/S (CPH:HART) makes use of debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
What Is Brødrene Hartmann's Net Debt?
The image below, which you can click on for greater detail, shows that Brødrene Hartmann had debt of kr.553.1m at the end of September 2020, a reduction from kr.674.5m over a year. However, it also had kr.147.6m in cash, and so its net debt is kr.405.5m.
How Strong Is Brødrene Hartmann's Balance Sheet?
The latest balance sheet data shows that Brødrene Hartmann had liabilities of kr.478.7m due within a year, and liabilities of kr.670.4m falling due after that. Offsetting this, it had kr.147.6m in cash and kr.467.1m in receivables that were due within 12 months. So it has liabilities totalling kr.534.4m more than its cash and near-term receivables, combined.
Given Brødrene Hartmann has a market capitalization of kr.3.50b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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).
Brødrene Hartmann has a low net debt to EBITDA ratio of only 0.75. And its EBIT covers its interest expense a whopping 25.4 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, Brødrene Hartmann grew its EBIT by 82% 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 you can't view debt in total isolation; since Brødrene Hartmann will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Brødrene Hartmann produced sturdy free cash flow equating to 55% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
The good news is that Brødrene Hartmann's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its EBIT growth rate also supports that impression! Zooming out, Brødrene Hartmann seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Brødrene Hartmann that you should be aware of.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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