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. Importantly, Wärtsilä Oyj Abp (HEL:WRT1V) does carry debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Wärtsilä Oyj Abp's Debt?
As you can see below, Wärtsilä Oyj Abp had €925.0m of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, it does have €383.0m in cash offsetting this, leading to net debt of about €542.0m.
How Healthy Is Wärtsilä Oyj Abp's Balance Sheet?
According to the last reported balance sheet, Wärtsilä Oyj Abp had liabilities of €2.55b due within 12 months, and liabilities of €1.36b due beyond 12 months. On the other hand, it had cash of €383.0m and €1.90b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €1.63b.
While this might seem like a lot, it is not so bad since Wärtsilä Oyj Abp has a market capitalization of €6.45b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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).
Wärtsilä Oyj Abp's net debt is only 0.91 times its EBITDA. And its EBIT covers its interest expense a whopping 19.2 times over. So we're pretty relaxed about its super-conservative use of debt. But the other side of the story is that Wärtsilä Oyj Abp saw its EBIT decline by 6.3% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Wärtsilä Oyj Abp 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Wärtsilä Oyj Abp recorded free cash flow worth 71% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
The good news is that Wärtsilä Oyj Abp's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its EBIT growth rate does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that Wärtsilä Oyj Abp can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. Given Wärtsilä Oyj Abp 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.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.