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. It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Adler Modemärkte AG (ETR:ADD) makes use of debt. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Adler Modemärkte's Debt?
As you can see below, Adler Modemärkte had €2.03m of debt at September 2019, down from €5.69m a year prior. But on the other hand it also has €46.4m in cash, leading to a €44.4m net cash position.
How Strong Is Adler Modemärkte's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Adler Modemärkte had liabilities of €107.5m due within 12 months and liabilities of €238.2m due beyond that. Offsetting these obligations, it had cash of €46.4m as well as receivables valued at €11.4m due within 12 months. So it has liabilities totalling €287.9m more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the €72.4m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Adler Modemärkte would probably need a major re-capitalization if its creditors were to demand repayment. Adler Modemärkte boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.
The bad news is that Adler Modemärkte saw its EBIT decline by 11% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. 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 Adler Modemärkte'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Adler Modemärkte may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Adler Modemärkte actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
While Adler Modemärkte does have more liabilities than liquid assets, it also has net cash of €44.4m. And it impressed us with free cash flow of €10m, being 162% of its EBIT. Despite its cash we think that Adler Modemärkte seems to struggle to handle its total liabilities, so we are wary of the stock. 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. Case in point: We've spotted 2 warning signs for Adler Modemärkte you should be aware of.
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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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