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. Above all, Metro AG (ETR:B4B) is in debt. But does this debt worry shareholders?
When is debt a problem?
Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. If things go really bad, lenders can take over the business. However, a more common (but still painful) scenario is that it has to raise new equity at a low price, thereby permanently diluting shareholders. 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 has is to look at its cash and debt together.
Check out our latest analysis for Metro
What is Metro’s net debt?
You can click on the chart below for historical numbers, but it shows Metro had €1.97 billion in debt in September 2021, up from €2.29 billion a year earlier. However, he also had €1.47 billion in cash, so his net debt is €498.0 million.
How strong is Metro’s balance sheet?
Zooming in on the latest balance sheet data, we can see that Metro had liabilities of €6.33 billion due within 12 months and liabilities of €4.65 billion due beyond. In return, it had 1.47 billion euros in cash and 1.05 billion euros in receivables due within 12 months. It therefore has liabilities totaling 8.45 billion euros more than its cash and short-term receivables, combined.
The deficiency here weighs heavily on the company itself of 3.69 billion euros, like a child struggling under the weight of a huge backpack full of books, his sports equipment and a trumpet. We would therefore be watching his balance sheet closely, no doubt. Ultimately, Metro would likely need a major recapitalization if its creditors were to demand repayment.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). Thus, we consider debt to earnings with and without amortization and depreciation expense.
Given that net debt is only 0.64 times EBITDA, it is initially surprising to see that Metro’s EBIT has a low interest coverage of 1.6 times. So, even if we are not necessarily alarmed, we think that his debt is far from trivial. Unfortunately, Metro’s EBIT actually fell 2.5% over the past year. If earnings continue to fall, managing that debt will be as difficult as delivering hot soup on a unicycle. The balance sheet is clearly the area to focus on when analyzing debt. But it’s future earnings, more than anything, that will determine Metro’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, a company can only repay its debts with cold 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, Metro has actually produced more free cash flow than EBIT. There’s nothing better than incoming money to stay in the good books of your lenders.
Our point of view
To be frank, Metro’s interest coverage and track record of keeping total liabilities under control makes us rather uncomfortable with its level of leverage. But on the bright side, its conversion from EBIT to free cash flow is a good sign and makes us more optimistic. Once we consider all of the above factors together, it seems to us that Metro’s debt makes it a bit risky. Some people like that kind of risk, but we’re aware of the potential pitfalls, so we’d probably prefer it to take on less debt. Even though Metro lost money on the bottom line, its positive EBIT suggests that the company itself has potential. You might want to check how income has changed over the past few years.
In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeat present.
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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.