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 “. It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. We note that RATH Aktiengesellschaft (LIFE:RAT) has a debt on its balance sheet. But the real question is whether this debt makes the business risky.
Why is debt risky?
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. By replacing dilution, however, debt can be a great tool for companies that need capital to invest in growth at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
See our latest analysis for RATH
What is RATH’s net debt?
The image below, which you can click on for more details, shows that in June 2022, RATH had a debt of 39.9 million euros, compared to 37.8 million euros in one year. However, he also had €7.63 million in cash, so his net debt is €32.2 million.
A Look at RATH’s Responsibilities
Zooming in on the latest balance sheet data, we can see that RATH had liabilities of €37.6m due within 12 months and liabilities of €26.3m due beyond. In return, it had €7.63 million in cash and €26.6 million in receivables due within 12 months. It therefore has liabilities totaling 29.6 million euros more than its cash and short-term receivables, combined.
That’s a mountain of leverage compared to its market capitalization of €39.0m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet quickly.
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.
RATH’s debt is 3.9 times its EBITDA, and its EBIT covers its interest expense 3.9 times. Taken together, this implies that, while we wouldn’t like to see debt levels increase, we think he can manage his current leverage. Another concern for investors could be that RATH’s EBIT fell 14% last year. If things continue like this, dealing with debt will be about as easy as putting an angry house cat in its travel box. There is no doubt that we learn the most about debt from the balance sheet. But you can’t look at debt in total isolation; since RATH will need income to repay this debt. So if you want to know more about his earnings, it might be worth checking out. this chart of its long-term earnings trend.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Over the past three years, RATH has produced strong free cash flow equivalent to 55% of its EBIT, which is what we expected. This cold hard cash allows him to reduce his debt whenever he wants.
Our point of view
To be frank, RATH’s net debt to EBITDA ratio and its history of (non-)growth in its EBIT make us rather uncomfortable with its debt levels. But at least it’s decent enough to convert EBIT to free cash flow; it’s encouraging. Overall, we think it’s fair to say that RATH has enough debt that there is real risk around the balance sheet. If all goes well, this should boost returns, but on the other hand, the risk of permanent capital loss is increased by debt. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks reside on the balance sheet, far from it. For example RATH has 4 warning signs (and 3 potentially serious) we think you should know.
If you are interested in investing in companies 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.
Valuation is complex, but we help make it simple.
Find out if RATH is potentially overvalued or undervalued by viewing our full analysis, which includes fair value estimates, risks and warnings, dividends, insider trading and financial health.
Feedback on this article? Concerned about content? Get in touch with us directly. You can also email the editorial team (at) Simplywallst.com.
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.
Comments are closed.