Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 Ubisoft Entertainment SA (EPA:UBI) makes use of debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Ubisoft Entertainment's Net Debt?
The image below, which you can click on for greater detail, shows that Ubisoft Entertainment had debt of €1.47b at the end of September 2020, a reduction from €1.85b over a year. However, it does have €1.28b in cash offsetting this, leading to net debt of about €191.5m.
A Look At Ubisoft Entertainment's Liabilities
According to the last reported balance sheet, Ubisoft Entertainment had liabilities of €1.14b due within 12 months, and liabilities of €1.42b due beyond 12 months. On the other hand, it had cash of €1.28b and €446.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €822.8m.
Since publicly traded Ubisoft Entertainment shares are worth a very impressive total of €9.36b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Ubisoft Entertainment has net debt of just 1.3 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 7.9 times the interest expense over the last year. On the other hand, Ubisoft Entertainment saw its EBIT drop by 9.0% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Ubisoft Entertainment's ability to maintain a healthy balance sheet going forward. 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 it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Ubisoft Entertainment's free cash flow amounted to 45% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Based on what we've seen Ubisoft Entertainment is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. In particular, we thought its interest cover was a positive. When we consider all the factors mentioned above, we do feel a bit cautious about Ubisoft Entertainment's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Ubisoft Entertainment is showing 2 warning signs in our investment analysis , and 1 of those shouldn't be ignored...
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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