Legendary fund manager Li Lu (who Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but the possibility that you will suffer a permanent loss of capital. 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. Like many other companies Orpéa SA (EPA: ORP) uses debt. But the most important question is: what risk does this debt create?
Why Does Debt Bring Risk?
Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. In the worst case scenario, a business 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, constantly diluting shareholders, just to strengthen its balance sheet. Of course, debt can be an important tool in businesses, especially capital intensive businesses. The first thing to do when considering how much debt a business uses is to look at its cash flow and debt together.
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What is Orpea’s debt?
The image below, which you can click for more details, shows that Orpea had a debt of € 8.26bn in June 2021, compared to € 7.07bn in one year. However, he also had 949.0 million euros in cash, so his net debt is 7.32 billion euros.
A look at Orpea’s liabilities
According to the latest published balance sheet, Orpea had liabilities of € 3.08bn less than 12 months and liabilities of € 11.1bn over 12 months. In return, he had € 949.0 million in cash and € 899.6 million in receivables due within 12 months. Its liabilities thus exceed the sum of its cash and its (short-term) receivables by € 12.3 billion.
The deficit here weighs heavily on the 6.42 billion euro company itself, as if a child struggles under the weight of a huge backpack full of books, his gym equipment and a trumpet. We therefore believe that shareholders should watch it closely. In the end, Orpea would likely need a major recapitalization if its creditors demanded repayment.
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). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt versus EBITDA) and the actual interest charges associated with this debt (with its coverage rate). interests).
Orpea has a fairly high debt / EBITDA ratio of 9.6 which suggests significant leverage. However, its interest coverage of 3.7 is reasonably strong, which is a good sign. On a lighter note, note that Orpea increased its EBIT by 29% last year. If sustained, this growth should cause this debt to evaporate like scarce drinking water during an unusually hot summer. The balance sheet is clearly the area you need to focus on when analyzing debt. But ultimately, the company’s future profitability will decide whether Orpea can strengthen its balance sheet over time. So, if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, a business needs free cash flow to repay its debts; accounting profits are not enough. It is therefore worth checking to what extent this EBIT is supported by free cash flow. Over the past three years, Orpea has recorded free cash flow of 66% of its EBIT, which is close to normal, given that free cash flow is understood to be excluding interest and taxes. This free cash flow puts the business in a good position to repay debt, if any.
Our point of view
Both Orpea’s total liability level and its net debt to EBITDA are discouraging. But on the bright side of life, its EBIT growth rate leaves us more cheerful. It should also be noted that healthcare companies like Orpea routinely use debt with no problem. Considering all of the above factors, we believe that Orpea’s debt poses risks to the business. While this debt may increase returns, we believe the company now has sufficient leverage. The balance sheet is clearly the area you need to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist off the balance sheet. We have identified 2 warning signs with Orpea (at least 1 which cannot be ignored), and understanding them should be part of your investment process.
If, after all of this, you’re more interested in a fast-growing company with a strong balance sheet, take a quick look at our list of cash-flow net-growth stocks.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in the mentioned stocks.
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