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 note that H&R GmbH & Co. KGaA (ETR:2HRA) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
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. If things get really bad, the lenders can take control of the business. 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. 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 H&R GmbH KGaA Carry?
The chart below, which you can click on for greater detail, shows that H&R GmbH KGaA had €135.5m in debt in June 2019; about the same as the year before. However, it does have €63.1m in cash offsetting this, leading to net debt of about €72.5m.
How Strong Is H&R GmbH KGaA's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that H&R GmbH KGaA had liabilities of €185.0m due within 12 months and liabilities of €209.9m due beyond that. Offsetting these obligations, it had cash of €63.1m as well as receivables valued at €100.7m due within 12 months. So it has liabilities totalling €231.2m more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's market capitalization of €189.8m, we think shareholders really should watch H&R GmbH KGaA's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While H&R GmbH KGaA's low debt to EBITDA ratio of 1.0 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.4 last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Shareholders should be aware that H&R GmbH KGaA's EBIT was down 36% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine H&R GmbH KGaA'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.
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, H&R GmbH KGaA saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, H&R GmbH KGaA's conversion of EBIT to free cash flow left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at managing its debt, based on its EBITDA,; that's encouraging. After considering the datapoints discussed, we think H&R GmbH KGaA has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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 H&R GmbH KGaA's earnings per share history for free.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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.