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 can see that Schneider Electric SE (EPA:SU) uses debt in its business. But should shareholders worry about its use of debt?
When is debt dangerous?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. 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. The first step when considering a company’s debt levels is to consider its cash and debt together.
Check out our latest analysis for Schneider Electric
What is Schneider Electric’s debt?
As you can see below, Schneider Electric had 9.75 billion euros in debt in December 2021, compared to 10.5 billion euros the previous year. However, he also had €2.63 billion in cash, so his net debt is €7.12 billion.
A look at Schneider Electric’s responsibilities
The latest balance sheet data shows that Schneider Electric had liabilities of 14.2 billion euros due within one year and liabilities of 12.2 billion euros due thereafter. In return, it had 2.63 billion euros in cash and 8.61 billion euros in receivables due within 12 months. It therefore has liabilities totaling 15.2 billion euros more than its cash and short-term receivables, combined.
Of course, Schneider Electric has a titanic market capitalization of 83.3 billion euros, so these liabilities are probably manageable. However, we think it’s worth keeping an eye on the strength of its balance sheet, as it can change over time.
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). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Schneider Electric’s net debt is only 1.3 times its EBITDA. And its EBIT easily covers its interest charges, which is 34.9 times the size. One could therefore say that he is no more threatened by his debt than an elephant is by a mouse. Another good sign, Schneider Electric was able to increase its EBIT by 24% in twelve months, thus facilitating the repayment of its debt. When analyzing debt levels, the balance sheet is the obvious starting point. But it is ultimately the company’s future profitability that will decide whether Schneider Electric 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. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Schneider Electric has recorded free cash flow representing 80% of its EBIT, which is higher than what we usually expect. This puts him in a very strong position to repay his debt.
Our point of view
Fortunately, Schneider Electric’s impressive interest coverage means it has the upper hand on its debt. And this is only the beginning of good news since its conversion of EBIT into free cash flow is also very pleasing. Overall, we think Schneider Electric’s use of debt seems entirely reasonable and we’re not worried about that. After all, reasonable leverage can increase return on equity. 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, we found 2 warning signs for Schneider Electric which you should be aware of before investing here.
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.
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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.
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