Does ERG (BIT:ERG) Have A Healthy Balance Sheet?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 note that ERG S.p.A. (BIT:ERG) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for ERG

What Is ERG's Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2021 ERG had €3.42b of debt, an increase on €2.16b, over one year. On the flip side, it has €1.28b in cash leading to net debt of about €2.13b.

How Strong Is ERG's Balance Sheet?

The latest balance sheet data shows that ERG had liabilities of €1.91b due within a year, and liabilities of €2.53b falling due after that. On the other hand, it had cash of €1.28b and €389.7m worth of receivables due within a year. So its liabilities total €2.76b more than the combination of its cash and short-term receivables.

ERG has a market capitalization of €4.67b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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).

ERG has a debt to EBITDA ratio of 4.7 and its EBIT covered its interest expense 6.5 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Also relevant is that ERG has grown its EBIT by a very respectable 20% in the last year, thus enhancing its ability to pay down debt. 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 ERG'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.

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. During the last three years, ERG generated free cash flow amounting to a very robust 95% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

On our analysis ERG's conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. In particular, net debt to EBITDA gives us cold feet. When we consider all the elements mentioned above, it seems to us that ERG is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. For example, we've discovered 3 warning signs for ERG (1 is a bit concerning!) that you should be aware of before investing here.

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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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.