We Think Compagnie Générale des Établissements Michelin Société en commandite par actions (EPA:ML) Can Stay On Top Of 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.' 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 Compagnie Générale des Établissements Michelin Société en commandite par actions (EPA:ML) makes use of debt. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.

See our latest analysis for Compagnie Générale des Établissements Michelin Société en commandite par actions

What Is Compagnie Générale des Établissements Michelin Société en commandite par actions's Debt?

You can click the graphic below for the historical numbers, but it shows that Compagnie Générale des Établissements Michelin Société en commandite par actions had €6.56b of debt in June 2022, down from €7.01b, one year before. However, because it has a cash reserve of €1.93b, its net debt is less, at about €4.63b.

How Strong Is Compagnie Générale des Établissements Michelin Société en commandite par actions' Balance Sheet?

We can see from the most recent balance sheet that Compagnie Générale des Établissements Michelin Société en commandite par actions had liabilities of €8.65b falling due within a year, and liabilities of €10.1b due beyond that. On the other hand, it had cash of €1.93b and €4.05b worth of receivables due within a year. So it has liabilities totalling €12.7b more than its cash and near-term receivables, combined.

This is a mountain of leverage even relative to its gargantuan market capitalization of €15.9b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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).

Compagnie Générale des Établissements Michelin Société en commandite par actions has a low net debt to EBITDA ratio of only 1.0. And its EBIT easily covers its interest expense, being 12.8 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The good news is that Compagnie Générale des Établissements Michelin Société en commandite par actions has increased its EBIT by 3.8% over twelve months, which should ease any concerns about debt repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Compagnie Générale des Établissements Michelin Société en commandite par actions's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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 most recent three years, Compagnie Générale des Établissements Michelin Société en commandite par actions 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.

Our View

When it comes to the balance sheet, the standout positive for Compagnie Générale des Établissements Michelin Société en commandite par actions was the fact that it seems able to cover its interest expense with its EBIT confidently. But the other factors we noted above weren't so encouraging. For instance it seems like it has to struggle a bit to handle its total liabilities. Looking at all this data makes us feel a little cautious about Compagnie Générale des Établissements Michelin Société en commandite par actions's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. Be aware that Compagnie Générale des Établissements Michelin Société en commandite par actions is showing 1 warning sign in our investment analysis , you should know about...

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. 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.