Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about. 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 can see that CEWE Stiftung & Co. KGaA (ETR:CWC) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is CEWE Stiftung KGaA's Debt?
As you can see below, CEWE Stiftung KGaA had €60.5m of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, because it has a cash reserve of €15.6m, its net debt is less, at about €45.0m.
How Strong Is CEWE Stiftung KGaA's Balance Sheet?
We can see from the most recent balance sheet that CEWE Stiftung KGaA had liabilities of €177.1m falling due within a year, and liabilities of €95.9m due beyond that. Offsetting this, it had €15.6m in cash and €66.9m in receivables that were due within 12 months. So its liabilities total €190.6m more than the combination of its cash and short-term receivables.
CEWE Stiftung KGaA has a market capitalization of €620.3m, so it could very likely raise cash to ameliorate 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 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.
CEWE Stiftung KGaA has a low net debt to EBITDA ratio of only 0.46. And its EBIT covers its interest expense a whopping 81.5 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. And we also note warmly that CEWE Stiftung KGaA grew its EBIT by 12% last year, making its debt load easier to handle. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if CEWE Stiftung KGaA can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, CEWE Stiftung KGaA'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.
The good news is that CEWE Stiftung KGaA's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that CEWE Stiftung KGaA can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of CEWE Stiftung KGaA's earnings per share history for free.
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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