We Think Construcciones y Auxiliar de Ferrocarriles (BME:CAF) Is Taking Some Risk With Its Debt

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. We can see that Construcciones y Auxiliar de Ferrocarriles, S.A. (BME:CAF) does use debt in its business. But should shareholders be worried about its use of debt?

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. If things get really bad, the lenders can take control of the business. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Construcciones y Auxiliar de Ferrocarriles

How Much Debt Does Construcciones y Auxiliar de Ferrocarriles Carry?

The image below, which you can click on for greater detail, shows that Construcciones y Auxiliar de Ferrocarriles had debt of €979.6m at the end of December 2020, a reduction from €1.07b over a year. However, it does have €675.9m in cash offsetting this, leading to net debt of about €303.7m.

How Strong Is Construcciones y Auxiliar de Ferrocarriles' Balance Sheet?

The latest balance sheet data shows that Construcciones y Auxiliar de Ferrocarriles had liabilities of €2.23b due within a year, and liabilities of €1.20b falling due after that. Offsetting this, it had €675.9m in cash and €1.54b in receivables that were due within 12 months. So it has liabilities totalling €1.22b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of €1.33b, so it does suggest shareholders should keep an eye on Construcciones y Auxiliar de Ferrocarriles' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Construcciones y Auxiliar de Ferrocarriles has net debt worth 1.9 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 2.7 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Unfortunately, Construcciones y Auxiliar de Ferrocarriles's EBIT flopped 10% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Construcciones y Auxiliar de Ferrocarriles'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Construcciones y Auxiliar de Ferrocarriles actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Neither Construcciones y Auxiliar de Ferrocarriles's ability to cover its interest expense with its EBIT nor its EBIT growth rate 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. Taking the abovementioned factors together we do think Construcciones y Auxiliar de Ferrocarriles's debt poses some risks to the business. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Construcciones y Auxiliar de Ferrocarriles (of which 1 is concerning!) you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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