Vallourec (EPA:VK) Has A Somewhat Strained Balance Sheet

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.' 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. As with many other companies Vallourec S.A. (EPA:VK) makes use of debt. But the real question is whether this debt is making the company risky.

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Vallourec

What Is Vallourec's Debt?

As you can see below, at the end of March 2023, Vallourec had €1.89b of debt, up from €1.61b a year ago. Click the image for more detail. On the flip side, it has €894.0m in cash leading to net debt of about €1.00b.

How Healthy Is Vallourec's Balance Sheet?

According to the last reported balance sheet, Vallourec had liabilities of €2.02b due within 12 months, and liabilities of €1.90b due beyond 12 months. Offsetting this, it had €894.0m in cash and €829.0m in receivables that were due within 12 months. So its liabilities total €2.20b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of €2.36b, so it does suggest shareholders should keep an eye on Vallourec's use of debt. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Vallourec has net debt of just 1.0 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 7.6 times, which is more than adequate. Even more impressive was the fact that Vallourec grew its EBIT by 200% over twelve months. 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Vallourec saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Vallourec's conversion of EBIT to free cash flow and level of total liabilities definitely weigh on it, in our esteem. But its EBIT growth rate tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Vallourec's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. Even though Vallourec lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check out how earnings have been trending over the last few years.

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.