Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Aevis Victoria SA (VTX:AEVS) makes use of debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Aevis Victoria Carry?
You can click the graphic below for the historical numbers, but it shows that Aevis Victoria had CHF366.8m of debt in June 2019, down from CHF1.08b, one year before. However, because it has a cash reserve of CHF34.5m, its net debt is less, at about CHF332.3m.
How Healthy Is Aevis Victoria's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Aevis Victoria had liabilities of CHF230.6m due within 12 months and liabilities of CHF407.9m due beyond that. Offsetting this, it had CHF34.5m in cash and CHF186.2m in receivables that were due within 12 months. So it has liabilities totalling CHF417.8m more than its cash and near-term receivables, combined.
This deficit isn't so bad because Aevis Victoria is worth CHF991.0m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While Aevis Victoria's low debt to EBITDA ratio of 1.3 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.9 last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Even more impressive was the fact that Aevis Victoria grew its EBIT by 1061% over twelve months. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Aevis Victoria will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Aevis Victoria saw substantial negative free cash flow, in total. 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.
Aevis Victoria's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better There's no doubt that its ability to grow its EBIT is pretty flash. We would also note that Healthcare industry companies like Aevis Victoria commonly do use debt without problems. When we consider all the factors mentioned above, we do feel a bit cautious about Aevis Victoria's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. Over time, share prices tend to follow earnings per share, so if you're interested in Aevis Victoria, you may well want to click here to check an interactive graph of its earnings per share history.
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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