David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital. 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 can see that adesso AG (ETR:ADN1) does use debt in its business. But is this debt a concern to shareholders?
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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is adesso's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 adesso had debt of €62.6m, up from €47.3m in one year. However, it does have €28.2m in cash offsetting this, leading to net debt of about €34.3m.
How Healthy Is adesso's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that adesso had liabilities of €115.0m due within 12 months and liabilities of €122.5m due beyond that. On the other hand, it had cash of €28.2m and €121.8m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €87.4m.
While this might seem like a lot, it is not so bad since adesso has a market capitalization of €311.3m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
adesso has a low net debt to EBITDA ratio of only 1.1. And its EBIT easily covers its interest expense, being 16.0 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, adesso saw its EBIT drop by 9.2% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine adesso'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.
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. Looking at the most recent three years, adesso recorded free cash flow of 32% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
On our analysis adesso's interest cover should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For example, its EBIT growth rate makes us a little nervous about its debt. When we consider all the factors mentioned above, we do feel a bit cautious about adesso's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. Over time, share prices tend to follow earnings per share, so if you're interested in adesso, you may well want to click here to check an interactive graph of its earnings per share history.
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.
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