Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Chr. Hansen Holding A/S (CPH:CHR) does carry debt. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Chr. Hansen Holding's Net Debt?
The image below, which you can click on for greater detail, shows that at May 2019 Chr. Hansen Holding had debt of €808.3m, up from €729.9m in one year. However, because it has a cash reserve of €68.3m, its net debt is less, at about €740.0m.
How Healthy Is Chr. Hansen Holding's Balance Sheet?
The latest balance sheet data shows that Chr. Hansen Holding had liabilities of €352.1m due within a year, and liabilities of €785.8m falling due after that. On the other hand, it had cash of €68.3m and €203.8m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €865.8m.
Of course, Chr. Hansen Holding has a titanic market capitalization of €10.1b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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).
Chr. Hansen Holding's net debt to EBITDA ratio of about 1.9 suggests only moderate use of debt. And its commanding EBIT of 48.1 times its interest expense, implies the debt load is as light as a peacock feather. We saw Chr. Hansen Holding grow its EBIT by 8.9% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Chr. Hansen Holding can strengthen its balance sheet over time. 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. Over the most recent three years, Chr. Hansen Holding recorded free cash flow worth 57% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Happily, Chr. Hansen Holding's impressive interest cover implies it has the upper hand on its debt. And we also thought its conversion of EBIT to free cash flow was a positive. When we consider the range of factors above, it looks like Chr. Hansen Holding is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. Over time, share prices tend to follow earnings per share, so if you're interested in Chr. Hansen Holding, you may well want to click here to check an interactive graph of its earnings per share history.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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. Thank you for reading.