Warren Buffett said: “Volatility is far from synonymous with risk”. When we think about how risky a business is, we always like to look at its use of debt because debt overload can lead to bankruptcy. Like many other companies ElringKlinger AG (ETR: ZIL2) uses debt. But should shareholders be concerned about its use of debt?
When is debt dangerous?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it exists at their mercy. If things really go wrong, lenders can take over the business. However, a more common (but still costly) situation is where a company has to dilute its shareholders at a cheap share price just to get its debt under control. By replacing dilution, however, debt can be a very good tool for companies 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 flow and debt together.
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How much debt does ElringKlinger have?
As you can see below, ElringKlinger had € 505.3 million in debt in March 2021, up from € 664.6 million the year before. However, he also had 164.8 million euros in cash, so his net debt is 340.5 million euros.
How healthy is ElringKlinger’s track record?
According to the latest published balance sheet, ElringKlinger had liabilities of € 597.0 million within 12 months and liabilities of € 563.0 million due beyond 12 months. In return, he had € 164.8 million in cash and € 265.0 million in receivables due within 12 months. It therefore has a total liability of € 730.2 million more than its combined cash and short-term receivables.
This deficit is sizable compared to his market capitalization of € 904.8 million, so he suggests shareholders keep an eye on the use of ElringKlinger’s debt. This suggests that shareholders would be heavily diluted if the company needed to consolidate its balance sheet quickly.
We measure a company’s debt load relative to its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT) covers its interest costs (interest coverage). Thus, we consider debt versus earnings with and without amortization charges.
ElringKlinger has net debt worth 1.9 times EBITDA, which isn’t too much, but its interest coverage looks a bit weak, with EBIT at just 4.5 times interest expense. . This is in large part due to the company’s large depreciation and amortization charges, which arguably means that its EBITDA is a very generous measure of profit, and its debt may be heavier than it appears. At first glance. Notably, ElringKlinger’s EBIT has been fairly stable over the past year. We would rather see some growth in earnings, as it always helps reduce debt. There is no doubt that we learn the most about debt from the balance sheet. But it is future profits, more than anything, that will determine ElringKlinger’s ability to maintain a healthy balance sheet in the future. So, if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, while the IRS may love accounting profits, lenders only accept hard cash. We therefore always check how much of this EBIT is converted into free cash flow. Fortunately for all shareholders, ElringKlinger has actually generated more free cash flow than EBIT over the past three years. This kind of cash conversion makes us as excited as the crowd when the pace drops at a Daft Punk concert.
Our point of view
When it comes to the balance sheet, the good thing about ElringKlinger was that he seems able to convert EBIT to free cash flow with confidence. However, our other observations were not so encouraging. For example, it looks like he has to struggle a bit to manage his total liabilities. When we consider all of the factors mentioned above, we feel a little cautious about ElringKlinger’s use of debt. While we understand that debt can improve returns on equity, we suggest shareholders watch their debt level closely, lest they increase. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist off the balance sheet. We have identified 1 warning sign with ElringKlinger, and understanding them should be part of your investment process.
At the end of the day, sometimes it’s easier to focus on businesses that don’t even need to go into debt. Readers can access a list of growth stocks with zero net debt 100% free, at present.
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