Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Koninklijke Philips N.V. (AMS:PHIA) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Koninklijke Philips Carry?
As you can see below, at the end of December 2020, Koninklijke Philips had €5.33b of debt, up from €4.07b a year ago. Click the image for more detail. However, because it has a cash reserve of €3.23b, its net debt is less, at about €2.11b.
A Look At Koninklijke Philips' Liabilities
We can see from the most recent balance sheet that Koninklijke Philips had liabilities of €7.74b falling due within a year, and liabilities of €8.08b due beyond that. On the other hand, it had cash of €3.23b and €4.31b worth of receivables due within a year. So its liabilities total €8.28b more than the combination of its cash and short-term receivables.
Since publicly traded Koninklijke Philips shares are worth a very impressive total of €42.3b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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). 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).
Koninklijke Philips's net debt is only 0.69 times its EBITDA. And its EBIT covers its interest expense a whopping 35.0 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In fact Koninklijke Philips's saving grace is its low debt levels, because its EBIT has tanked 30% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Koninklijke Philips's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Koninklijke Philips recorded free cash flow worth 76% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Happily, Koninklijke Philips's impressive interest cover implies it has the upper hand on its debt. But the stark truth is that we are concerned by its EBIT growth rate. We would also note that Medical Equipment industry companies like Koninklijke Philips commonly do use debt without problems. Looking at all the aforementioned factors together, it strikes us that Koninklijke Philips can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Koninklijke Philips you should know about.
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.
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