Here's Why ELES Semiconductor Equipment (BIT:ELES) Has A Meaningful Debt Burden

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 can see that ELES Semiconductor Equipment S.p.A. (BIT:ELES) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

View our latest analysis for ELES Semiconductor Equipment

How Much Debt Does ELES Semiconductor Equipment Carry?

The image below, which you can click on for greater detail, shows that ELES Semiconductor Equipment had debt of €6.83m at the end of June 2020, a reduction from €8.92m over a year. On the flip side, it has €4.27m in cash leading to net debt of about €2.56m.

How Strong Is ELES Semiconductor Equipment's Balance Sheet?

According to the last reported balance sheet, ELES Semiconductor Equipment had liabilities of €6.86m due within 12 months, and liabilities of €5.78m due beyond 12 months. Offsetting these obligations, it had cash of €4.27m as well as receivables valued at €7.76m due within 12 months. So it has liabilities totalling €603.0k more than its cash and near-term receivables, combined.

This state of affairs indicates that ELES Semiconductor Equipment's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the €33.9m company is short on cash, but still worth keeping an eye on the balance sheet.

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.

ELES Semiconductor Equipment's net debt is only 1.1 times its EBITDA. And its EBIT covers its interest expense a whopping 10.7 times over. So we're pretty relaxed about its super-conservative use of debt. The modesty of its debt load may become crucial for ELES Semiconductor Equipment if management cannot prevent a repeat of the 40% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine ELES Semiconductor Equipment'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, ELES Semiconductor Equipment recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

While ELES Semiconductor Equipment's conversion of EBIT to free cash flow makes us cautious about it, its track record of (not) growing its EBIT is no better. But at least its interest cover is a gleaming silver lining to those clouds. Taking the abovementioned factors together we do think ELES Semiconductor Equipment's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. To that end, you should learn about the 3 warning signs we've spotted with ELES Semiconductor Equipment (including 2 which is are potentially serious) .

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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This article by Simply Wall St is general in nature. 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.
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