Is Applus Services (BME:APPS) 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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Applus Services, S.A. (BME:APPS) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Applus Services

How Much Debt Does Applus Services Carry?

As you can see below, at the end of December 2020, Applus Services had €714.6m of debt, up from €599.7m a year ago. Click the image for more detail. On the flip side, it has €192.1m in cash leading to net debt of about €522.5m.

How Strong Is Applus Services' Balance Sheet?

The latest balance sheet data shows that Applus Services had liabilities of €478.6m due within a year, and liabilities of €1.04b falling due after that. On the other hand, it had cash of €192.1m and €341.1m worth of receivables due within a year. So it has liabilities totalling €989.9m more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of €1.29b, so it does suggest shareholders should keep an eye on Applus Services' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Applus Services's net debt to EBITDA ratio of about 1.6 suggests only moderate use of debt. And its commanding EBIT of 11.8 times its interest expense, implies the debt load is as light as a peacock feather. In addition to that, we're happy to report that Applus Services has boosted its EBIT by 68%, thus reducing the spectre of future debt repayments. 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 Applus Services 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Applus Services 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

Applus Services's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its level of total liabilities. When we consider the range of factors above, it looks like Applus Services is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Applus Services has 2 warning signs (and 1 which is significant) 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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