Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 can see that Signify N.V. (AMS:LIGHT) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Signify's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Signify had €1.76b of debt in December 2021, down from €2.07b, one year before. However, because it has a cash reserve of €851.0m, its net debt is less, at about €908.0m.
A Look At Signify's Liabilities
Zooming in on the latest balance sheet data, we can see that Signify had liabilities of €2.82b due within 12 months and liabilities of €2.84b due beyond that. On the other hand, it had cash of €851.0m and €1.21b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €3.60b.
This is a mountain of leverage relative to its market capitalization of €4.73b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). 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).
Signify's net debt is only 1.1 times its EBITDA. And its EBIT easily covers its interest expense, being 25.1 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. And we also note warmly that Signify grew its EBIT by 15% last year, making its debt load easier to handle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Signify'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. Happily for any shareholders, Signify actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Happily, Signify's impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its level of total liabilities does undermine this impression a bit. When we consider the range of factors above, it looks like Signify is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. 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. For instance, we've identified 3 warning signs for Signify that you should be aware of.
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.
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.