Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. We can see that Encavis S.A. (ETR:ECV) uses debt in its business. But the more important question is: what risk does this debt create?
What risk does debt carry?
Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. If things go really bad, lenders can take over the business. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. Of course, many companies use debt to finance their growth, without any negative consequences. When we look at debt levels, we first consider cash and debt levels, together.
See our latest analysis for Encavis
What is Encavis’ debt?
As you can see below, at the end of September 2021, Encavis had 1.71 billion euros in debt, compared to 1.61 billion euros a year ago. Click on the image for more details. However, he has €200.0 million in cash to offset this, resulting in a net debt of around €1.51 billion.
A look at Encavis’ responsibilities
We can see from the most recent balance sheet that Encavis had liabilities of 228.3 million euros due in one year, and liabilities of 2.01 billion euros due beyond. In return for these obligations, it had cash of €200.0 million as well as receivables worth €80.5 million at less than 12 months. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables by €1.96 billion.
This deficit is considerable compared to its market capitalization of 2.15 billion euros, so it suggests that shareholders monitor the use of debt by Encavis. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet quickly.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
Encavis shareholders face the double whammy of a high net debt to EBITDA ratio (6.8) and fairly low interest coverage, as EBIT is only 1.7 times the charge of interests. This means that we would consider him to be heavily indebted. On a lighter note, note that Encavis has increased its EBIT by 27% over the past year. If he can sustain that kind of improvement, his debt load will start to melt like glaciers in a warming world. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future earnings, more than anything, that will determine Encavis’ 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.
But our last consideration is also important, because a company cannot pay off its debts with paper profits; he needs cash. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Encavis has actually produced more free cash flow than EBIT. This kind of high cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Our point of view
We weren’t impressed with Encavis’ interest coverage, and its net debt to EBITDA made us cautious. But its conversion from EBIT to free cash flow has been significantly rewarding. Looking at all this data, we feel a little cautious about Encavis’ debt levels. While debt has its upside in higher potential returns, we think shareholders should certainly consider how debt levels might make the stock more risky. The balance sheet is clearly the area to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist outside of the balance sheet. Example: we have identified 4 warning signs for Encavis you need to be aware of, and 1 of them should not be ignored.
If you are interested in investing in businesses that can generate profits without the burden of debt, then check out this free list of growing companies that have net cash on the balance sheet.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.