David Iben put it well when he said, “Volatility is not a risk we care about. What matters to us is to avoid the 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 Evonik Industries SA (ETR: EVK) uses debt. But does this debt worry shareholders?
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company cannot repay it easily, either by raising capital or with its own 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) situation is where a company has to dilute its shareholders at a cheap share price just to get its debt under control. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash flow and debt together.
Check out our latest review for Evonik Industries
What is Evonik Industries’ debt?
You can click on the graph below for historical figures, but it shows that Evonik Industries had € 3.86 billion in debt in September 2021, up from € 4.57 billion a year earlier. However, because it has a cash reserve of € 1.20 billion, its net debt is lower, at around € 2.66 billion.
A look at the responsibilities of Evonik Industries
The latest balance sheet data shows Evonik Industries had debts of 3.57 billion euros due within one year, and debts of 8.87 billion euros due thereafter. In return, he had € 1.20 billion in cash and € 2.01 billion in receivables due within 12 months. It therefore has liabilities totaling 9.23 billion euros more than its combined cash and short-term receivables.
That’s a mountain of leverage even compared to its gargantuan market capitalization of € 13.3 billion. This suggests that shareholders would be greatly 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 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.
Evonik Industries’ net debt is only 1.2 times its EBITDA. And its EBIT covers its interest costs a whopping 12.4 times. We could therefore say that he is no more threatened by his debt than an elephant is by a mouse. Also positive, Evonik Industries has increased its EBIT by 25% over the past year, which should make it easier to repay debt going forward. The balance sheet is clearly the area to focus on when analyzing debt. But it is future profits, more than anything, that will determine Evonik Industries’ 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 needs free cash flow to pay off 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, Evonik Industries has generated strong free cash flow equivalent to 72% of its EBIT, roughly what we expected. This hard cash allows him to reduce his debt whenever he wants.
Our point of view
Evonik Industries’ interest coverage suggests he can manage his debt as easily as Cristiano Ronaldo could score a goal against an Under-14 goalkeeper. But, on a darker note, we’re a little concerned with its total liability level. Considering all of this data, it seems to us that Evonik Industries is taking a pretty sane approach to debt. This means that they are taking a bit more risk, in the hope of increasing shareholder returns. 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. Concrete example: we have spotted 1 warning sign for Evonik Industries you must be aware.
If you want to invest in companies that can generate profits without the burden of debt, 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 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.