Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Elastron S.A. - Steel Service Centers (ATH:ELSTR) 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. 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, 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.
How Much Debt Does Elastron - Steel Service Centers Carry?
The image below, which you can click on for greater detail, shows that at December 2020 Elastron - Steel Service Centers had debt of €41.5m, up from €37.5m in one year. However, because it has a cash reserve of €10.9m, its net debt is less, at about €30.6m.
How Healthy Is Elastron - Steel Service Centers' Balance Sheet?
The latest balance sheet data shows that Elastron - Steel Service Centers had liabilities of €25.1m due within a year, and liabilities of €37.8m falling due after that. On the other hand, it had cash of €10.9m and €18.2m worth of receivables due within a year. So it has liabilities totalling €33.7m more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company's €32.5m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Weak interest cover of 1.5 times and a disturbingly high net debt to EBITDA ratio of 7.6 hit our confidence in Elastron - Steel Service Centers like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. However, the silver lining was that Elastron - Steel Service Centers achieved a positive EBIT of €1.3m in the last twelve months, an improvement on the prior year's loss. When analysing debt levels, the balance sheet is the obvious place to start. But it is Elastron - Steel Service Centers's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Elastron - Steel Service Centers saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
On the face of it, Elastron - Steel Service Centers's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to grow its EBIT isn't such a worry. After considering the datapoints discussed, we think Elastron - Steel Service Centers has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Elastron - Steel Service Centers (of which 1 doesn't sit too well with us!) you should know about.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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