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We Think Sogeclair (EPA:SOG) Is Taking Some Risk With Its Debt

Simply Wall St

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. As with many other companies Sogeclair SA (EPA:SOG) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Sogeclair

What Is Sogeclair's Debt?

The image below, which you can click on for greater detail, shows that at December 2018 Sogeclair had debt of €33.9m, up from €28.8m in one year. However, it does have €19.5m in cash offsetting this, leading to net debt of about €14.4m.

ENXTPA:SOG Historical Debt, August 1st 2019

How Healthy Is Sogeclair's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Sogeclair had liabilities of €70.8m due within 12 months and liabilities of €31.3m due beyond that. Offsetting these obligations, it had cash of €19.5m as well as receivables valued at €60.3m due within 12 months. So it has liabilities totalling €22.2m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Sogeclair is worth €88.6m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Sogeclair's net debt is only 1.1 times its EBITDA. And its EBIT easily covers its interest expense, being 23.3 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In fact Sogeclair's saving grace is its low debt levels, because its EBIT has tanked 25% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Sogeclair 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 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 last three years, Sogeclair reported free cash flow worth 17% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Sogeclair's EBIT growth rate and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Taking the abovementioned factors together we do think Sogeclair's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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 Sogeclair'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.