Eurocell (LON:ECEL) Seems To Use Debt Quite Sensibly

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Eurocell plc (LON:ECEL) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Eurocell

What Is Eurocell's Net Debt?

The image below, which you can click on for greater detail, shows that Eurocell had debt of UK£17.0m at the end of December 2020, a reduction from UK£39.5m over a year. However, because it has a cash reserve of UK£7.10m, its net debt is less, at about UK£9.90m.

How Strong Is Eurocell's Balance Sheet?

According to the last reported balance sheet, Eurocell had liabilities of UK£57.7m due within 12 months, and liabilities of UK£56.5m due beyond 12 months. Offsetting this, it had UK£7.10m in cash and UK£38.5m in receivables that were due within 12 months. So it has liabilities totalling UK£68.6m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Eurocell is worth UK£262.4m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Eurocell's low debt to EBITDA ratio of 0.49 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.5 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. It is just as well that Eurocell's load is not too heavy, because its EBIT was down 52% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Eurocell'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Eurocell recorded free cash flow worth 66% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Eurocell's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to handle its debt, based on its EBITDA, is pretty flash. Looking at all this data makes us feel a little cautious about Eurocell's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Eurocell is showing 1 warning sign in our investment analysis , you should know about...

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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