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. We can see that Graines Voltz S.A. (EPA:GRVO) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 Graines Voltz's Net Debt?
The image below, which you can click on for greater detail, shows that at September 2021 Graines Voltz had debt of €39.7m, up from €38.0m in one year. However, because it has a cash reserve of €7.22m, its net debt is less, at about €32.5m.
How Healthy Is Graines Voltz's Balance Sheet?
We can see from the most recent balance sheet that Graines Voltz had liabilities of €45.2m falling due within a year, and liabilities of €20.4m due beyond that. Offsetting these obligations, it had cash of €7.22m as well as receivables valued at €36.5m due within 12 months. So it has liabilities totalling €22.0m more than its cash and near-term receivables, combined.
Of course, Graines Voltz has a market capitalization of €194.9m, so these liabilities are probably manageable. 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
We'd say that Graines Voltz's moderate net debt to EBITDA ratio ( being 2.2), indicates prudence when it comes to debt. And its strong interest cover of 38.3 times, makes us even more comfortable. It is well worth noting that Graines Voltz's EBIT shot up like bamboo after rain, gaining 95% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Graines Voltz's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Considering the last three years, Graines Voltz actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.
Graines Voltz's interest cover was a real positive on this analysis, as was its EBIT growth rate. In contrast, our confidence was undermined by its apparent struggle to convert EBIT to free cash flow. When we consider all the elements mentioned above, it seems to us that Graines Voltz is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. To that end, you should be aware of the 1 warning sign we've spotted with Graines Voltz .
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.