Does Valeo (EPA:FR) Have A Healthy Balance Sheet?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 note that Valeo SE (EPA:FR) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

See our latest analysis for Valeo

What Is Valeo's Debt?

As you can see below, Valeo had €5.39b of debt at December 2021, down from €5.80b a year prior. However, because it has a cash reserve of €2.42b, its net debt is less, at about €2.98b.

How Healthy Is Valeo's Balance Sheet?

The latest balance sheet data shows that Valeo had liabilities of €8.48b due within a year, and liabilities of €5.86b falling due after that. On the other hand, it had cash of €2.42b and €3.07b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €8.86b.

This deficit casts a shadow over the €4.67b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Valeo 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).

Valeo's net debt is 2.7 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 12.1 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Notably, Valeo made a loss at the EBIT level, last year, but improved that to positive EBIT of €714m in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Valeo can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. In the last year, Valeo's free cash flow amounted to 39% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Mulling over Valeo's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Overall, we think it's fair to say that Valeo has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. To that end, you should be aware of the 2 warning signs we've spotted with Valeo .

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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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.