Stock Analysis

Is ERG (BIT:ERG) Using Too Much Debt?

BIT:ERG
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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. As with many other companies ERG S.p.A. (BIT:ERG) makes use of debt. But should shareholders be worried about its use of debt?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

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How Much Debt Does ERG Carry?

As you can see below, ERG had €1.54b of debt at September 2022, down from €2.59b a year prior. However, it does have €1.22b in cash offsetting this, leading to net debt of about €325.9m.

debt-equity-history-analysis
BIT:ERG Debt to Equity History February 23rd 2023

How Healthy Is ERG's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that ERG had liabilities of €6.00m due within 12 months and liabilities of €2.34b due beyond that. Offsetting these obligations, it had cash of €1.22b as well as receivables valued at €315.6m due within 12 months. So it has liabilities totalling €812.3m more than its cash and near-term receivables, combined.

This deficit isn't so bad because ERG is worth €4.05b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

ERG's net debt is only 0.57 times its EBITDA. And its EBIT easily covers its interest expense, being 12.6 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Better yet, ERG grew its EBIT by 124% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if ERG can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, ERG burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Happily, ERG's impressive interest cover implies it has the upper hand on its debt. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. All these things considered, it appears that ERG can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. Be aware that ERG is showing 3 warning signs in our investment analysis , and 2 of those are concerning...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

Valuation is complex, but we're here to simplify it.

Discover if ERG might be undervalued or overvalued with our detailed analysis, featuring fair value estimates, potential risks, dividends, insider trades, and its financial condition.

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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.