Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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. We note that Dr. Hönle AG (ETR:HNL) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Dr. Hönle's Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Dr. Hönle had debt of €12.3m, up from €7.86m in one year. However, its balance sheet shows it holds €15.4m in cash, so it actually has €3.14m net cash.
How Healthy Is Dr. Hönle's Balance Sheet?
We can see from the most recent balance sheet that Dr. Hönle had liabilities of €23.8m falling due within a year, and liabilities of €23.0m due beyond that. Offsetting this, it had €15.4m in cash and €18.7m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €12.7m.
Since publicly traded Dr. Hönle shares are worth a total of €248.3m, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Dr. Hönle also has more cash than debt, so we're pretty confident it can manage its debt safely.
On the other hand, Dr. Hönle saw its EBIT drop by 9.5% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Dr. Hönle'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. Dr. Hönle 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. In the last three years, Dr. Hönle's free cash flow amounted to 30% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
We could understand if investors are concerned about Dr. Hönle's liabilities, but we can be reassured by the fact it has has net cash of €3.1m. So we don't have any problem with Dr. Hönle's use of debt. Over time, share prices tend to follow earnings per share, so if you're interested in Dr. Hönle, you may well want to click here to check an interactive graph of its earnings per share history.
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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