The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. 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. Importantly, ORPEA Société Anonyme (EPA:ORP) does carry debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is ORPEA Société Anonyme's Debt?
As you can see below, at the end of December 2018, ORPEA Société Anonyme had €5.88b of debt, up from €5.09b a year ago. Click the image for more detail. On the flip side, it has €776.0m in cash leading to net debt of about €5.10b.
How Strong Is ORPEA Société Anonyme's Balance Sheet?
We can see from the most recent balance sheet that ORPEA Société Anonyme had liabilities of €1.94b falling due within a year, and liabilities of €6.23b due beyond that. On the other hand, it had cash of €776.0m and €806.5m worth of receivables due within a year. So its liabilities total €6.59b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of €7.10b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
ORPEA Société Anonyme has a rather high debt to EBITDA ratio of 8.4 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 4.2 times, suggesting it can responsibly service its obligations. The good news is that ORPEA Société Anonyme improved its EBIT by 8.5% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine ORPEA Société Anonyme'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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, ORPEA Société Anonyme recorded free cash flow worth 51% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
ORPEA Société Anonyme's struggle handle its debt, based on its EBITDA, had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. But on the bright side, its ability to grow its EBIT isn't too shabby at all. We should also note that Healthcare industry companies like ORPEA Société Anonyme commonly do use debt without problems. Taking the abovementioned factors together we do think ORPEA Société Anonyme's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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 ORPEA Société Anonyme's earnings per share history for free.
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 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.