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 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 UCB SA (EBR:UCB) does use debt in its business. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is UCB's Debt?
As you can see below, UCB had €1.28b of debt at June 2019, down from €1.67b a year prior. However, because it has a cash reserve of €1.12b, its net debt is less, at about €153.0m.
A Look At UCB's Liabilities
According to the last reported balance sheet, UCB had liabilities of €2.38b due within 12 months, and liabilities of €1.68b due beyond 12 months. On the other hand, it had cash of €1.12b and €990.0m worth of receivables due within a year. So its liabilities total €1.95b more than the combination of its cash and short-term receivables.
Of course, UCB has a titanic market capitalization of €12.3b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. But either way, UCB has virtually no net debt, so it's fair to say it does not have a heavy debt load!
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
UCB's net debt is only 0.12 times its EBITDA. And its EBIT easily covers its interest expense, being 19.4 times the size. So we're pretty relaxed about its super-conservative use of debt. On the other hand, UCB's EBIT dived 12%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 UCB can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, UCB produced sturdy free cash flow equating to 64% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
On our analysis UCB's interest cover should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. In particular, EBIT growth rate gives us cold feet. Considering this range of data points, we think UCB is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. Over time, share prices tend to follow earnings per share, so if you're interested in UCB, you may well want to click here to check an interactive graph of its earnings per share history.
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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