Warren Buffett said: “Volatility is far from synonymous with risk. So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. We can see that LANXESS Aktiengesellschaft (ETR:LXS) uses debt in its business. But the real question is whether this debt makes the business risky.

When is debt a problem?

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. In the worst case, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, many companies use debt to finance their growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.

See our latest analysis for LANXESS

What is LANXESS’ debt?

The graph below, which you can click on for more details, shows that LANXESS had a debt of 2.87 billion euros in September 2021; about the same as the previous year. However, since it has a cash reserve of 500.0 million euros, its net debt is lower, at around 2.37 billion euros.

How strong is LANXESS’ balance sheet?

The latest balance sheet data shows that LANXESS had liabilities of €1.65 billion due within one year, and liabilities of €4.32 billion falling due thereafter. In return, it had 500.0 million euros in cash and 1.16 billion euros in receivables due within 12 months. It therefore has liabilities totaling 4.31 billion euros more than its cash and short-term receivables, combined.

This deficit is considerable compared to its market capitalization of 5.06 billion euros, so it suggests that shareholders monitor the use of debt by LANXESS. 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). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.

LANXESS’s net debt is 2.6 times its EBITDA, which represents significant but still reasonable leverage. But its EBIT was around 1,000 times its interest expense, implying that the company isn’t really paying a high cost to maintain that level of leverage. Even if the low cost turns out to be unsustainable, that’s a good sign. It is important to note that LANXESS has increased its EBIT by 42% over the last twelve months, and this growth will make it easier to manage its debt. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether LANXESS can strengthen its balance sheet over time. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.

Finally, while the taxman may love accounting profits, lenders only accept cash. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Over the past three years, LANXESS has recorded free cash flow of 14% of its EBIT, which is really quite low. For us, such a low cash conversion creates a bit of paranoia about the ability to extinguish the debt.

Our point of view

LANXESS’s interest coverage was a real bright spot in this analysis, as was its EBIT growth rate. That said, its conversion of EBIT to free cash flow does make us somewhat aware of potential future risks to the balance sheet. When we consider all the factors mentioned above, we feel a bit cautious about LANXESS’ use of debt. While we understand that debt can improve return on equity, we suggest shareholders keep a close eye on their level of debt, lest it 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 outside of the balance sheet. To do this, you need to find out about the 4 warning signs we spotted with LANXESS (including 1 which does not suit us too much).

In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% free, at present.

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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.