The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Koninklijke DSM N.V. (AMS:DSM) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
Check out our latest analysis for Koninklijke DSM
What Is Koninklijke DSM's Debt?
The image below, which you can click on for greater detail, shows that at December 2020 Koninklijke DSM had debt of €3.37b, up from €2.42b in one year. However, it does have €914.0m in cash offsetting this, leading to net debt of about €2.46b.
How Strong Is Koninklijke DSM's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Koninklijke DSM had liabilities of €2.26b due within 12 months and liabilities of €4.61b due beyond that. Offsetting these obligations, it had cash of €914.0m as well as receivables valued at €1.48b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €4.48b.
Of course, Koninklijke DSM has a titanic market capitalization of €25.2b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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.
Koninklijke DSM's net debt of 2.0 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 9.2 times interest expense) certainly does not do anything to dispel this impression. Unfortunately, Koninklijke DSM's EBIT flopped 17% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. 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 Koninklijke DSM'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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Koninklijke DSM recorded free cash flow worth a fulsome 86% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
Our View
On our analysis Koninklijke DSM's conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. In particular, EBIT growth rate gives us cold feet. When we consider all the elements mentioned above, it seems to us that Koninklijke DSM is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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 example, we've discovered 2 warning signs for Koninklijke DSM that you should be aware of before investing here.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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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About ENXTAM:DSM
DSM-Firmenich
Provides solutions for nutrition, health, and beauty businesses in the Switzerland, Netherlands, rest of Europe, the Middle East and Africa, North America, Latin America, China, and rest of Asia.
Very undervalued with flawless balance sheet.
