Here's Why Vallourec (EPA:VK) Has A Meaningful Debt Burden

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.' 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. Importantly, Vallourec S.A. (EPA:VK) does carry debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Vallourec

What Is Vallourec's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Vallourec had €1.91b of debt in June 2021, down from €3.76b, one year before. However, because it has a cash reserve of €1.22b, its net debt is less, at about €689.9m.

A Look At Vallourec's Liabilities

The latest balance sheet data shows that Vallourec had liabilities of €1.52b due within a year, and liabilities of €1.84b falling due after that. Offsetting this, it had €1.22b in cash and €587.9m in receivables that were due within 12 months. So it has liabilities totalling €1.56b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of €1.68b, so it does suggest shareholders should keep an eye on Vallourec's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Even though Vallourec's debt is only 2.0, its interest cover is really very low at 0.63. In large part that's it has so much depreciation and amortisation. These charges may be non-cash, so they could be excluded when it comes to paying down debt. But the accounting charges are there for a reason -- some assets are seen to be losing value. In any case, it's safe to say the company has meaningful debt. We also note that Vallourec improved its EBIT from a last year's loss to a positive €142m. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Vallourec's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Vallourec saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Vallourec's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least its net debt to EBITDA is not so bad. We're quite clear that we consider Vallourec to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 1 warning sign we've spotted with Vallourec .

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.

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.

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