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. As with many other companies VERBUND AG (VIE:VER) makes use of debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is VERBUND's Net Debt?
As you can see below, VERBUND had €2.23b of debt at June 2019, down from €2.38b a year prior. However, because it has a cash reserve of €212.4m, its net debt is less, at about €2.01b.
How Healthy Is VERBUND's Balance Sheet?
The latest balance sheet data shows that VERBUND had liabilities of €1.74b due within a year, and liabilities of €3.98b falling due after that. Offsetting this, it had €212.4m in cash and €701.2m in receivables that were due within 12 months. So it has liabilities totalling €4.81b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since VERBUND has a huge market capitalization of €16.9b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).
VERBUND's net debt of 2.0 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 7.7 times interest expense) certainly does not do anything to dispel this impression. VERBUND grew its EBIT by 8.1% in the last year. That's far from incredible but it is a good thing, when it comes to paying off 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 VERBUND'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, VERBUND recorded free cash flow worth 79% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
VERBUND's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And we also thought its interest cover was a positive. It's also worth noting that VERBUND is in the Electric Utilities industry, which is often considered to be quite defensive. When we consider the range of factors above, it looks like VERBUND is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. Over time, share prices tend to follow earnings per share, so if you're interested in VERBUND, 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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.