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Here's Why Knorr-Bremse (ETR:KBX) Can Manage Its Debt Responsibly

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Knorr-Bremse Aktiengesellschaft (ETR:KBX) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Knorr-Bremse

What Is Knorr-Bremse's Debt?

As you can see below, at the end of March 2019, Knorr-Bremse had €1.71b of debt, up from €763.9m a year ago. Click the image for more detail. However, it also had €1.61b in cash, and so its net debt is €105.5m.

XTRA:KBX Historical Debt, September 9th 2019
XTRA:KBX Historical Debt, September 9th 2019

How Strong Is Knorr-Bremse's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Knorr-Bremse had liabilities of €2.56b due within 12 months and liabilities of €2.53b due beyond that. Offsetting this, it had €1.61b in cash and €1.74b in receivables that were due within 12 months. So it has liabilities totalling €1.75b more than its cash and near-term receivables, combined.

Given Knorr-Bremse has a humongous market capitalization of €13.8b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Carrying virtually no net debt, Knorr-Bremse has a very light debt load indeed.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Knorr-Bremse has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.088 and EBIT of 27.0 times the interest expense. Indeed relative to its earnings its debt load seems light as a feather. Also good is that Knorr-Bremse grew its EBIT at 11% over the last year, further increasing its ability to manage 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 Knorr-Bremse'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 company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Knorr-Bremse's free cash flow amounted to 48% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Happily, Knorr-Bremse's impressive interest cover implies it has the upper hand on its debt. And we also thought its net debt to EBITDA was a positive. Taking all this data into account, it seems to us that Knorr-Bremse takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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 Knorr-Bremse's earnings per share history for free.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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 editorial-team@simplywallst.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.