Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say this when he says “The biggest risk in investing is not price volatility, but if you will suffer a loss. permanent capital “. So it can be obvious that you need to consider debt, when you think about how risky a given stock is, because too much debt can sink a business. We notice that HORNBACH Holding AG & Co. KGaA (ETR: HBH) has debt on its balance sheet. But the real question is whether this debt makes the business risky.
What risk does debt entail?
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. While it’s not too common, we often see indebted companies continually diluting their shareholders because lenders are forcing them to raise capital at a ridiculous price. Of course, debt can be an important tool in businesses, especially capital intensive businesses. The first step in examining a business’s debt levels is to consider its cash flow and debt together.
See our latest analysis for HORNBACH Holding KGaA
What is the debt of HORNBACH Holding KGaA?
As you can see below, HORNBACH Holding KGaA had a debt of 679.3 million euros in November 2021, up from 734.6 million euros the previous year. However, because it has a cash reserve of € 537.0 million, its net debt is lower, at around € 142.3 million.
A look at the liabilities of HORNBACH Holding KGaA
Zooming in on the latest balance sheet data, we can see that HORNBACH Holding KGaA had liabilities of 803.5 million euros due within 12 months and liabilities of 1.45 billion euros due beyond. In compensation for these commitments, he had cash of € 537.0 million as well as receivables valued at € 69.5 million within 12 months. Its liabilities therefore amount to € 1.64 billion more than the combination of its cash and short-term receivables.
This is a mountain of leverage compared to its market capitalization of 2.06 billion euros. If its lenders asked it to consolidate the balance sheet, shareholders would likely face severe dilution.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its earnings before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
HORNBACH Holding KGaA has net debt of only 0.34 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is underpinned by the strong interest coverage, with EBIT representing 7.1 times last year’s interest expense. But the bad news is that HORNBACH Holding KGaA has seen its EBIT fall by 19% over the past twelve months. We believe that type of performance, if repeated frequently, could well cause difficulties for the title. When analyzing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the company will decide whether HORNBACH Holding KGaA can strengthen its balance sheet over time. So, if you want to see what the professionals think, you might find this free Analyst Profit Forecast report interesting.
But our last consideration is also important, because a business cannot pay its debts with paper profits; he needs hard cash. The logical step is therefore to examine the proportion of this EBIT that corresponds to the actual free cash flow. Over the past three years, HORNBACH Holding KGaA has generated strong free cash flow equivalent to 57% of its EBIT, roughly what we expected. This hard cash allows him to reduce his debt whenever he wants.
Our point of view
HORNBACH Holding KGaA’s EBIT growth rate has been a real negative on this analysis, although other factors we have taken into account cast it in a significantly better light. In particular, its net debt to EBITDA has reinvigorated itself. When we consider all the factors mentioned, it seems to us that HORNBACH Holding KGaA is taking risks with its recourse to debt. So while this leverage increases returns on equity, we wouldn’t really want to see it increase from here. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks lie on the balance sheet – far from it. Note that HORNBACH Holding KGaA displays 1 warning sign in our investment analysis , you must know…
At the end of the day, it’s often best to focus on businesses that don’t have net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.
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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 any stock 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 documents. Simply Wall St has no position in any of the stocks mentioned.