Is Verallia Société Anonyme (EPA:VRLA) Using Too Much Debt?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 note that Verallia Société Anonyme (EPA:VRLA) does have debt on its balance sheet. 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

Our analysis indicates that VRLA is potentially undervalued!

What Is Verallia Société Anonyme's Net Debt?

As you can see below, Verallia Société Anonyme had €1.76b of debt, at June 2022, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has €652.3m in cash leading to net debt of about €1.11b.

How Healthy Is Verallia Société Anonyme's Balance Sheet?

We can see from the most recent balance sheet that Verallia Société Anonyme had liabilities of €1.24b falling due within a year, and liabilities of €2.00b due beyond that. On the other hand, it had cash of €652.3m and €283.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €2.30b.

This deficit is considerable relative to its market capitalization of €3.15b, so it does suggest shareholders should keep an eye on Verallia Société Anonyme's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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.

Verallia Société Anonyme's net debt is only 1.4 times its EBITDA. And its EBIT easily covers its interest expense, being 18.2 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also good is that Verallia Société Anonyme grew its EBIT at 16% over the last year, further increasing its ability to manage debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Verallia Société Anonyme can strengthen its balance sheet over time. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Verallia Société Anonyme recorded free cash flow worth a fulsome 84% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

Happily, Verallia Société Anonyme's impressive interest cover implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its level of total liabilities. When we consider the range of factors above, it looks like Verallia Société Anonyme is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Verallia Société Anonyme that you should be aware of before investing here.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.