Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about. 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 Sanofi (EPA:SAN) makes use of debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Sanofi Carry?
You can click the graphic below for the historical numbers, but it shows that Sanofi had €25.5b of debt in June 2019, down from €28.9b, one year before. However, it also had €6.74b in cash, and so its net debt is €18.8b.
How Strong Is Sanofi's Balance Sheet?
We can see from the most recent balance sheet that Sanofi had liabilities of €19.2b falling due within a year, and liabilities of €34.8b due beyond that. Offsetting this, it had €6.74b in cash and €7.23b in receivables that were due within 12 months. So it has liabilities totalling €40.1b more than its cash and near-term receivables, combined.
Sanofi has a very large market capitalization of €104.6b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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.
We'd say that Sanofi's moderate net debt to EBITDA ratio ( being 1.9), indicates prudence when it comes to debt. And its strong interest cover of 14.7 times, makes us even more comfortable. Importantly Sanofi's EBIT was essentially flat over the last twelve months. Ideally it can diminish its debt load by kick-starting earnings growth. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Sanofi can strengthen its balance sheet over time. 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 always check how much of that EBIT is translated into free cash flow. During the last three years, Sanofi produced sturdy free cash flow equating to 77% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
The good news is that Sanofi's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! All these things considered, it appears that Sanofi can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. Given Sanofi has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
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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