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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Immo-Zenobe Gramme SA (EBR:ZEN) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Immo-Zenobe Gramme's Debt?
The image below, which you can click on for greater detail, shows that Immo-Zenobe Gramme had debt of €10.2m at the end of December 2018, a reduction from €10.9m over a year. On the flip side, it has €1.21m in cash leading to net debt of about €9.02m.
How Strong Is Immo-Zenobe Gramme's Balance Sheet?
We can see from the most recent balance sheet that Immo-Zenobe Gramme had liabilities of €1.94m falling due within a year, and liabilities of €9.47m due beyond that. On the other hand, it had cash of €1.21m and €201.9k worth of receivables due within a year. So its liabilities total €9.99m more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company's market capitalization of €9.93m, we think shareholders really should watch Immo-Zenobe Gramme's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Weak interest cover of 1.1 times and a disturbingly high net debt to EBITDA ratio of 5.2 hit our confidence in Immo-Zenobe Gramme like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. However, one redeeming factor is that Immo-Zenobe Gramme grew its EBIT at 12% over the last 12 months, boosting its ability to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Immo-Zenobe Gramme will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Considering the last three years, Immo-Zenobe Gramme actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
On the face of it, Immo-Zenobe Gramme's net debt to EBITDA left us tentative about the stock, and its interest cover was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, it seems to us that Immo-Zenobe Gramme's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. While Immo-Zenobe Gramme didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away.Click here to see if its earnings are heading in the right direction, over the medium term.
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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