These 4 Measures Indicate That Stern Groep (AMS:STRN) Is Using Debt In A Risky Way

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 can see that Stern Groep N.V. (AMS:STRN) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Stern Groep

How Much Debt Does Stern Groep Carry?

As you can see below, Stern Groep had €100.0m of debt at June 2020, down from €153.3m a year prior. On the flip side, it has €12.5m in cash leading to net debt of about €87.6m.

How Strong Is Stern Groep's Balance Sheet?

According to the last reported balance sheet, Stern Groep had liabilities of €230.6m due within 12 months, and liabilities of €105.6m due beyond 12 months. Offsetting this, it had €12.5m in cash and €44.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €279.0m.

This deficit casts a shadow over the €66.7m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Stern Groep would probably need a major re-capitalization if its creditors were to demand repayment.

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).

Stern Groep shareholders face the double whammy of a high net debt to EBITDA ratio (5.0), and fairly weak interest coverage, since EBIT is just 0.65 times the interest expense. The debt burden here is substantial. One redeeming factor for Stern Groep is that it turned last year's EBIT loss into a gain of €4.0m, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Stern Groep 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Stern Groep burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Stern Groep's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. Taking into account all the aforementioned factors, it looks like Stern Groep has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. Case in point: We've spotted 2 warning signs for Stern Groep you should be aware of, and 1 of them is potentially serious.

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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