David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Elecster Oyj (HEL:ELEAV) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Elecster Oyj's Net Debt?
The image below, which you can click on for greater detail, shows that Elecster Oyj had debt of €17.2m at the end of December 2020, a reduction from €18.2m over a year. However, because it has a cash reserve of €7.34m, its net debt is less, at about €9.87m.
A Look At Elecster Oyj's Liabilities
Zooming in on the latest balance sheet data, we can see that Elecster Oyj had liabilities of €10.7m due within 12 months and liabilities of €12.0m due beyond that. On the other hand, it had cash of €7.34m and €7.91m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €7.52m.
Elecster Oyj has a market capitalization of €35.8m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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.
We'd say that Elecster Oyj's moderate net debt to EBITDA ratio ( being 1.6), indicates prudence when it comes to debt. And its commanding EBIT of 32.7 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 Elecster Oyj has boosted its EBIT by 77%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But it is Elecster Oyj's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Elecster Oyj recorded free cash flow worth 56% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Elecster Oyj's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Looking at the bigger picture, we think Elecster Oyj's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. 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. We've identified 4 warning signs with Elecster Oyj (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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