Vallourec (EPA:VK) Has A Pretty Healthy Balance Sheet

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Vallourec S.A. (EPA:VK) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. 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 think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Vallourec

How Much Debt Does Vallourec Carry?

You can click the graphic below for the historical numbers, but it shows that Vallourec had €1.68b of debt in September 2023, down from €1.78b, one year before. However, it also had €938.0m in cash, and so its net debt is €741.0m.

How Healthy Is Vallourec's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Vallourec had liabilities of €1.86b due within 12 months and liabilities of €1.87b due beyond that. On the other hand, it had cash of €938.0m and €765.0m worth of receivables due within a year. So its liabilities total €2.03b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of €3.06b. 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.

With net debt sitting at just 0.61 times EBITDA, Vallourec is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 9.7 times the interest expense over the last year. Better yet, Vallourec grew its EBIT by 219% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Vallourec 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Vallourec reported free cash flow worth 5.9% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

When it comes to the balance sheet, the standout positive for Vallourec was the fact that it seems able to grow its EBIT confidently. However, our other observations weren't so heartening. In particular, conversion of EBIT to free cash flow gives us cold feet. Considering this range of data points, we think Vallourec is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. For instance, we've identified 1 warning sign for Vallourec that you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.