Sphera Franchise Group (BVB:SFG) Has A Somewhat Strained Balance Sheet

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.' 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 Sphera Franchise Group S.A. (BVB:SFG) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Sphera Franchise Group

What Is Sphera Franchise Group's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2020 Sphera Franchise Group had debt of RON146.1m, up from RON121.2m in one year. However, it does have RON80.9m in cash offsetting this, leading to net debt of about RON65.2m.

How Strong Is Sphera Franchise Group's Balance Sheet?

The latest balance sheet data shows that Sphera Franchise Group had liabilities of RON202.2m due within a year, and liabilities of RON296.4m falling due after that. Offsetting these obligations, it had cash of RON80.9m as well as receivables valued at RON29.1m due within 12 months. So it has liabilities totalling RON388.6m more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of RON512.2m, so it does suggest shareholders should keep an eye on Sphera Franchise Group's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Sphera Franchise Group has a very low debt to EBITDA ratio of 1.1 so it is strange to see weak interest coverage, with last year's EBIT being only 2.2 times the interest expense. So one way or the other, it's clear the debt levels are not trivial. Shareholders should be aware that Sphera Franchise Group's EBIT was down 47% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Sphera Franchise Group 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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Sphera Franchise Group's free cash flow amounted to 34% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

To be frank both Sphera Franchise Group's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at managing its debt, based on its EBITDA,; that's encouraging. We're quite clear that we consider Sphera Franchise Group to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. To that end, you should learn about the 2 warning signs we've spotted with Sphera Franchise Group (including 1 which is is a bit concerning) .

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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