Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that EL.En. S.p.A. (BIT:ELN) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. 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.
How Much Debt Does EL.En Carry?
As you can see below, at the end of June 2019, EL.En had €20.1m of debt, up from €11.6m a year ago. Click the image for more detail. However, it does have €85.0m in cash offsetting this, leading to net cash of €64.9m.
How Strong Is EL.En's Balance Sheet?
The latest balance sheet data shows that EL.En had liabilities of €141.5m due within a year, and liabilities of €31.5m falling due after that. On the other hand, it had cash of €85.0m and €109.6m worth of receivables due within a year. So it can boast €21.6m more liquid assets than total liabilities.
This surplus suggests that EL.En has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, EL.En boasts net cash, so it's fair to say it does not have a heavy debt load!
The good news is that EL.En has increased its EBIT by 5.7% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine EL.En'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. EL.En 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. Over the last three years, EL.En reported free cash flow worth 19% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
While we empathize with investors who find debt concerning, you should keep in mind that EL.En has net cash of €64.9m, as well as more liquid assets than liabilities. And it also grew its EBIT by 5.7% over the last year. So we are not troubled with EL.En's debt use. Over time, share prices tend to follow earnings per share, so if you're interested in EL.En, 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.