Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from 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. We can see that Ercros, SA (BME: ECR) uses debt in its business. But the real question is whether this debt makes the business risky.
What risk does debt entail?
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) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. When we think of a business’s use of debt, we first look at cash flow and debt together.
See our latest analysis for Ercros
What is the debt of Erros?
You can click on the graph below for the historical figures, but it shows that Erros had 122.3 million euros in debt as of December 2020, up from 169.2 million euros a year earlier. However, it has € 39.9million in cash offsetting this, which leads to net debt of around € 82.3million.
A look at the responsibilities of Erros
Zooming in on the latest balance sheet data, we can see that Erros had a liability of € 163.8 million due within 12 months and a liability of € 142.2 million due beyond. On the other hand, it had cash of € 39.9 million and € 56.8 million in receivables within one year. Its liabilities thus exceed the sum of its cash and its receivables (short term) by € 209.2 million.
This deficit is considerable compared to its market capitalization of € 338.3m, so he suggests shareholders keep an eye on the use of Erros debt. If its lenders asked it to consolidate the balance sheet, shareholders would likely face severe dilution.
In order to measure a company’s debt relative to its profits, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its profit before interest and taxes (EBIT) divided by its interest. debtors (its interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Ercros has a net debt of 2.3 times EBITDA, which is not too much, but its interest coverage seems a bit weak, with EBIT at just 2.9 times interest expense. It appears the company incurs significant depreciation and amortization costs, so perhaps its debt load is heavier than it first appears, since EBITDA is arguably a generous measure of profits. Shareholders should know that Ercros’ EBIT fell 44% last year. If this decline continues, it will be more difficult to pay off the debt than to sell foie gras at a vegan convention. The balance sheet is clearly the area to focus on when analyzing debt. But it is future profits, more than anything, that will determine Erros’ ability to maintain a healthy balance sheet going forward. So, if you want to see what the professionals think, you might find this free Analyst Profit Forecast report interesting.
Finally, a business can only pay off its debts with hard cash, not with book profits. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years Ercros has generated free cash flow amounting to a very solid 86% of its EBIT, more than we expected. This puts him in a very strong position to pay off the debt.
Our point of view
Neither Ercros’ ability to increase its EBIT nor its interest coverage gave us confidence in its ability to take on more debt. But the good news is that it looks like it can easily convert EBIT into free cash flow. Taking the above factors together, we believe that Ercros’ debt presents certain risks to the business. So while this leverage increases returns on equity, we wouldn’t really want to see it increase from here. When analyzing debt levels, the balance sheet is the obvious place to start. But at the end of the day, every business can contain risks that exist off the balance sheet. Concrete example: we have spotted 4 warning signs for Ercros you need to be aware of it, and one of them is a little rude.
If you want to invest in companies that can generate profits without the burden of debt, check out this free list of growing companies that have net cash on the balance sheet.
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