Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say “The biggest risk in investing is not price volatility, but whether 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. Above all, Wachenheim Castle AG (ETR: SWA) carries the debt. But does this debt concern shareholders?
When Is Debt a Problem?
Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. If things really go wrong, lenders can take over the business. 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, many companies use debt to finance their growth without negative consequences. When we look at debt levels, we first consider both cash and debt levels.
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How much debt does Wachenheim Castle carry?
You can click on the graph below for the historical figures, but it shows that Wachenheim Castle had 44.9 million euros in debt in June 2021, up from 55.4 million euros a year earlier. However, because it has a cash reserve of € 7.68 million, its net debt is lower, at around € 37.2 million.
A look at the responsibilities of Wachenheim Castle
According to the latest published balance sheet, Schloss Wachenheim had liabilities of 115.0 million euros at 12 months and liabilities of 48.0 million euros over 12 months. In compensation for these obligations, he had cash of € 7.68 million as well as receivables valued at € 62.8 million within 12 months. Its liabilities therefore amount to € 92.5 million more than the combination of its cash and short-term receivables.
This is a mountain of leverage compared to its market capitalization of € 135.4 million. This suggests that shareholders would be heavily diluted if the company needed to consolidate its balance sheet quickly.
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 profit 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.
Wachenheim Castle’s net debt is only 1.1 times its EBITDA. And its EBIT covers its interest costs 25.3 times more. We could therefore say that he is no more threatened by his debt than an elephant is by a mouse. Also positive, Schloss Wachenheim increased its EBIT by 29% last year, which should make it easier to repay debt in the future. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future profits, more than anything, that will determine Schloss Wachenheim’s ability to maintain a healthy balance sheet going forward. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
Finally, a business can only pay off its debts with hard cash, not with book profits. 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, Wachenheim Castle has recorded free cash flow of 59% of its EBIT, which is close to normal given that free cash flow excludes interest and taxes. This free cash flow puts the business in a good position to repay debt, if any.
Our point of view
The good news is that Schloss Wachenheim’s demonstrated ability to cover his interest costs with his EBIT thrills us like a fluffy puppy does a toddler. But, on a darker note, we’re a little concerned with its total liability level. When we consider the above range of factors, it looks like Schloss Wachenheim is pretty reasonable with its use of debt. This means that they are taking a bit more risk, in the hope of increasing returns for shareholders. Over time, stock prices tend to follow earnings per share, so if you’re interested in Schloss Wachenheim, you can click here to view an interactive graph of its historical earnings per share.
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 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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