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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Fresenius SE & Co. KGaA (FRA:FRE) 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Fresenius SE KGaA's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Fresenius SE KGaA had debt of €20.7b, up from €19.0b in one year. However, it also had €1.46b in cash, and so its net debt is €19.2b.
How Strong Is Fresenius SE KGaA's Balance Sheet?
The latest balance sheet data shows that Fresenius SE KGaA had liabilities of €13.7b due within a year, and liabilities of €25.8b falling due after that. On the other hand, it had cash of €1.46b and €7.23b worth of receivables due within a year. So it has liabilities totalling €30.9b more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's massive market capitalization of €23.7b, we think shareholders really should watch Fresenius SE 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.
Fresenius SE KGaA's debt is 3.3 times its EBITDA, and its EBIT cover its interest expense 6.8 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. We saw Fresenius SE KGaA grow its EBIT by 2.3% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Fresenius SE KGaA's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Fresenius SE KGaA's free cash flow amounted to 40% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Mulling over Fresenius SE KGaA's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. We should also note that Healthcare industry companies like Fresenius SE KGaA commonly do use debt without problems. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Fresenius SE KGaA stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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 Fresenius SE 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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
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.