The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. As with many other companies Ovaro Kiinteistösijoitus Oyj (HEL:OVARO) makes use of debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
View our latest analysis for Ovaro Kiinteistösijoitus Oyj
What Is Ovaro Kiinteistösijoitus Oyj's Debt?
The image below, which you can click on for greater detail, shows that Ovaro Kiinteistösijoitus Oyj had debt of €42.4m at the end of December 2020, a reduction from €65.3m over a year. On the flip side, it has €4.94m in cash leading to net debt of about €37.5m.
How Strong Is Ovaro Kiinteistösijoitus Oyj's Balance Sheet?
We can see from the most recent balance sheet that Ovaro Kiinteistösijoitus Oyj had liabilities of €7.44m falling due within a year, and liabilities of €49.9m due beyond that. On the other hand, it had cash of €4.94m and €199.0k worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €52.2m.
When you consider that this deficiency exceeds the company's €36.3m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Ovaro Kiinteistösijoitus Oyj shareholders face the double whammy of a high net debt to EBITDA ratio (13.1), and fairly weak interest coverage, since EBIT is just 1.5 times the interest expense. The debt burden here is substantial. Another concern for investors might be that Ovaro Kiinteistösijoitus Oyj's EBIT fell 17% in the last year. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. 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 Ovaro Kiinteistösijoitus Oyj 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Ovaro Kiinteistösijoitus Oyj created free cash flow amounting to 18% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
Our View
On the face of it, Ovaro Kiinteistösijoitus Oyj's interest cover left us tentative about the stock, and its net debt to EBITDA was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its EBIT growth rate also fails to instill confidence. Taking into account all the aforementioned factors, it looks like Ovaro Kiinteistösijoitus Oyj has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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 2 warning signs with Ovaro Kiinteistösijoitus Oyj , and understanding them should be part of your investment process.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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This article by Simply Wall St is general in nature. 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.
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About HLSE:OVARO
Adequate balance sheet and slightly overvalued.
