Stock Analysis

Construcciones y Auxiliar de Ferrocarriles (BME:CAF) Has A Somewhat Strained Balance Sheet

BME:CAF
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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. We can see that Construcciones y Auxiliar de Ferrocarriles, S.A. (BME:CAF) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out the opportunities and risks within the ES Machinery industry.

What Is Construcciones y Auxiliar de Ferrocarriles's Debt?

The image below, which you can click on for greater detail, shows that Construcciones y Auxiliar de Ferrocarriles had debt of €928.6m at the end of June 2022, a reduction from €994.2m over a year. However, it does have €615.7m in cash offsetting this, leading to net debt of about €312.9m.

debt-equity-history-analysis
BME:CAF Debt to Equity History November 6th 2022

A Look At Construcciones y Auxiliar de Ferrocarriles' Liabilities

We can see from the most recent balance sheet that Construcciones y Auxiliar de Ferrocarriles had liabilities of €2.53b falling due within a year, and liabilities of €1.16b due beyond that. Offsetting these obligations, it had cash of €615.7m as well as receivables valued at €1.88b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €1.18b.

Given this deficit is actually higher than the company's market capitalization of €949.9m, we think shareholders really should watch Construcciones y Auxiliar de Ferrocarriles's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Construcciones y Auxiliar de Ferrocarriles has net debt worth 1.7 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 3.6 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Importantly Construcciones y Auxiliar de Ferrocarriles's EBIT was essentially flat over the last twelve months. We would prefer to see some earnings growth, because that always helps diminish debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Construcciones y Auxiliar de Ferrocarriles 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, 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. Over the last three years, Construcciones y Auxiliar de Ferrocarriles recorded free cash flow worth a fulsome 81% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

Neither Construcciones y Auxiliar de Ferrocarriles's ability to handle its total liabilities nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. When we consider all the factors discussed, it seems to us that Construcciones y Auxiliar de Ferrocarriles is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For example, we've discovered 2 warning signs for Construcciones y Auxiliar de Ferrocarriles (1 doesn't sit too well with us!) that you should be aware of before investing here.

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.