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 Koninklijke Vopak N.V. (AMS:VPK) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. 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 step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Koninklijke Vopak Carry?
The image below, which you can click on for greater detail, shows that at June 2019 Koninklijke Vopak had debt of €2.15b, up from €1.76b in one year. However, because it has a cash reserve of €92.5m, its net debt is less, at about €2.05b.
How Strong Is Koninklijke Vopak's Balance Sheet?
The latest balance sheet data shows that Koninklijke Vopak had liabilities of €1.06b due within a year, and liabilities of €2.57b falling due after that. Offsetting this, it had €92.5m in cash and €234.1m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €3.30b.
While this might seem like a lot, it is not so bad since Koninklijke Vopak has a market capitalization of €5.60b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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 Vopak has a debt to EBITDA ratio of 3.3 and its EBIT covered its interest expense 5.3 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Importantly Koninklijke Vopak's EBIT was essentially flat over the last twelve months. We would prefer to see some earnings growth, because that always helps diminish debt. 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 Vopak'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Koninklijke Vopak produced sturdy free cash flow equating to 58% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Koninklijke Vopak's net debt to EBITDA and level of total liabilities definitely weigh on it, in our esteem. But we do take some comfort from its conversion of EBIT to free cash flow. Looking at all the angles mentioned above, it does seem to us that Koninklijke Vopak is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. Over time, share prices tend to follow earnings per share, so if you're interested in Koninklijke Vopak, you may well want to click here to check an interactive graph of its earnings per share history.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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