We Think Obrascón Huarte Lain (BME:OHLA) Is Taking Some Risk With Its Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Obrascón Huarte Lain, S.A. (BME:OHLA) does carry debt. But the real question is whether this debt is making the company risky.

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. If things get really bad, the lenders can take control of the business. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Obrascón Huarte Lain

How Much Debt Does Obrascón Huarte Lain Carry?

You can click the graphic below for the historical numbers, but it shows that Obrascón Huarte Lain had €528.0m of debt in December 2022, down from €659.5m, one year before. However, because it has a cash reserve of €517.7m, its net debt is less, at about €10.3m.

How Healthy Is Obrascón Huarte Lain's Balance Sheet?

We can see from the most recent balance sheet that Obrascón Huarte Lain had liabilities of €1.99b falling due within a year, and liabilities of €648.3m due beyond that. On the other hand, it had cash of €517.7m and €1.47b worth of receivables due within a year. So its liabilities total €654.1m more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the €307.3m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Obrascón Huarte Lain would likely require a major re-capitalisation if it had to pay its creditors today.

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).

Obrascón Huarte Lain has a net debt to EBITDA ratio of 0.08, suggesting a very conservative balance sheet. But EBIT was only 0.77 times the interest expense last year, which shows that the debt has negatively impacted the business, by constraining its options (and restricting its free cash flow). Importantly, Obrascón Huarte Lain grew its EBIT by 87% over the last twelve months, and that growth will make it easier to handle its 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 Obrascón Huarte Lain 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last two years, Obrascón Huarte Lain saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Obrascón Huarte Lain's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. We're quite clear that we consider Obrascón Huarte Lain to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Obrascón Huarte Lain you should be aware of.

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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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.