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.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Musée Grévin SA (EPA:GREV) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Musée Grévin’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 Musée Grévin had €3.39m of debt, an increase on none, over one year. However, because it has a cash reserve of €373.1k, its net debt is less, at about €3.02m.
A Look At Musée Grévin’s Liabilities
Zooming in on the latest balance sheet data, we can see that Musée Grévin had liabilities of €3.25m due within 12 months and liabilities of €4.51m due beyond that. Offsetting these obligations, it had cash of €373.1k as well as receivables valued at €1.15m due within 12 months. So it has liabilities totalling €6.23m more than its cash and near-term receivables, combined.
Given Musée Grévin has a market capitalization of €32.5m, it’s hard to believe these liabilities pose much threat. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse. Because it carries more debt than cash, we think it’s worth watching Musée Grévin’s balance sheet over time.
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). 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).
Musée Grévin’s net debt to EBITDA ratio of about 1.50 suggests only moderate use of debt. And its commanding EBIT of 79.5 times its interest expense, implies the debt load is as light as a peacock feather. Shareholders should be aware that Musée Grévin’s EBIT was down 88% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There’s no doubt that we learn most about debt from the balance sheet. But it is Musée Grévin’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.
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. Over the last three years, Musée Grévin recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
Musée Grévin’s EBIT growth rate and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Musée Grévin is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. Over time, share prices tend to follow earnings per share, so if you’re interested in Musée Grévin, you may well want to click here to check an interactive graph of its earnings per share history.
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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If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.