Here’s why K+S (ETR:SDF) has significant leverage
Howard Marks said it well when he said that, rather than worrying about stock price volatility, “the possibility of permanent loss is the risk I worry about…and that every practical investor that I know is worried”. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. Like many other companies K+S Aktiengesellschaft (ETR:SDF) uses debt. But does this debt worry shareholders?
Why is debt risky?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. 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. By replacing dilution, however, debt can be a great tool for companies that need capital to invest in growth at high rates of return. When we look at debt levels, we first consider cash and debt levels, together.
Check out our latest analysis for K+S
What is K+S’s net debt?
As you can see below, K+S had 1.19 billion euros in debt in December 2021, compared to 3.37 billion euros the previous year. However, he also had €666.6 million in cash, so his net debt is €524.4 million.
How strong is K+S’s balance sheet?
According to the last published balance sheet, K+S had liabilities of 995.5 million euros maturing within 12 months and liabilities of 2.44 billion euros maturing beyond 12 months. In return, it had €666.6 million in cash and €643.9 million in receivables due within 12 months. It therefore has liabilities totaling 2.13 billion euros more than its cash and short-term receivables, combined.
This shortfall is not that bad as K+S is worth 6.21 billion euros and therefore could probably raise enough capital to shore up its balance sheet, should the need arise. But we definitely want to keep our eyes peeled for indications that its debt is too risky.
We measure a company’s leverage against 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 charge (interest coverage). Thus, we consider debt to earnings with and without amortization and depreciation expense.
K+S has a low net debt to EBITDA ratio of just 0.80. And its EBIT easily covers its interest charges, which is 30.1 times the size. One could therefore say that he is no more threatened by his debt than an elephant is by a mouse. Although K+S recorded a loss in EBIT last year, it was also good to see that it generated 395 million euros in EBIT over the last twelve months. There is no doubt that we learn the most about debt from the balance sheet. But it is future earnings, more than anything, that will determine K+S’s ability to maintain a healthy balance sheet in the future. 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. It is therefore worth checking how much of earnings before interest and tax (EBIT) is supported by free cash flow. Considering last year, K+S actually had a cash outflow, overall. Debt is much riskier for companies with unreliable free cash flow, so shareholders must hope that past spending will produce free cash flow in the future.
Our point of view
K+S’s EBIT to free cash flow conversion and the level of total liabilities are certainly weighing on it, in our view. But his coverage of interest tells a very different story and suggests a certain resilience. From all the angles mentioned above, it seems to us that K+S is a bit of a risky investment due to its leverage. This isn’t necessarily a bad thing, since leverage can increase return on equity, but it is something to be aware of. There is no doubt that we learn the most about debt from the balance sheet. 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 3 warning signs we spotted some with K+S (including 2 potentially serious ones).
If, after all that, you’re more interested in a fast-growing company with a strong balance sheet, check out our list of cash-neutral growth stocks right away.
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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.