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 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. Importantly, Fiducial Real Estate SA (EPA:ORIA) does carry debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Fiducial Real Estate’s Net Debt?
The chart below, which you can click on for greater detail, shows that Fiducial Real Estate had €256.0m in debt in September 2019; about the same as the year before. On the flip side, it has €33.8m in cash leading to net debt of about €222.3m.
How Healthy Is Fiducial Real Estate’s Balance Sheet?
We can see from the most recent balance sheet that Fiducial Real Estate had liabilities of €120.5m falling due within a year, and liabilities of €213.5m due beyond that. Offsetting these obligations, it had cash of €33.8m as well as receivables valued at €14.6m due within 12 months. So its liabilities total €285.6m more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of €473.1m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Fiducial Real Estate’s debt is 4.5 times its EBITDA, and its EBIT cover its interest expense 5.2 times over. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. We saw Fiducial Real Estate grow its EBIT by 3.4% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since Fiducial Real Estate will need earnings to service that debt. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
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 most recent three years, Fiducial Real Estate recorded free cash flow worth 58% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Fiducial Real Estate’s net debt to EBITDA was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its conversion of EBIT to free cash flow is relatively strong. Looking at all the angles mentioned above, it does seem to us that Fiducial Real Estate is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Fiducial Real Estate is showing 1 warning sign in our investment analysis , you should know about…
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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