Is Construcciones y Auxiliar de Ferrocarriles (BME:CAF) Using Too Much Debt?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. Importantly, Construcciones y Auxiliar de Ferrocarriles, S.A. (BME:CAF) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. 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.

View our latest analysis for Construcciones y Auxiliar de Ferrocarriles

What Is Construcciones y Auxiliar de Ferrocarriles's Debt?

The image below, which you can click on for greater detail, shows that at June 2020 Construcciones y Auxiliar de Ferrocarriles had debt of €1.21b, up from €1.15b in one year. However, because it has a cash reserve of €773.6m, its net debt is less, at about €434.7m.

How Healthy Is Construcciones y Auxiliar de Ferrocarriles's Balance Sheet?

According to the last reported balance sheet, Construcciones y Auxiliar de Ferrocarriles had liabilities of €2.47b due within 12 months, and liabilities of €1.30b due beyond 12 months. Offsetting these obligations, it had cash of €773.6m as well as receivables valued at €1.50b due within 12 months. So it has liabilities totalling €1.49b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of €1.31b, 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.

While we wouldn't worry about Construcciones y Auxiliar de Ferrocarriles's net debt to EBITDA ratio of 3.0, we think its super-low interest cover of 1.8 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Worse, Construcciones y Auxiliar de Ferrocarriles's EBIT was down 44% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that 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 Construcciones y Auxiliar de Ferrocarriles can strengthen its balance sheet over time. 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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Construcciones y Auxiliar de Ferrocarriles 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

To be frank both Construcciones y Auxiliar de Ferrocarriles's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Looking at the bigger picture, it seems clear to us that Construcciones y Auxiliar de Ferrocarriles's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. Take risks, for example - Construcciones y Auxiliar de Ferrocarriles has 5 warning signs (and 1 which makes us a bit uncomfortable) we think you should know about.

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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