Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. We note that Allreal Holding SA (VTX:ALLN) has debt on its balance sheet. 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. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still costly) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business has is to look at its cash and debt together.
Discover our latest analysis for Allreal Holding
What is Allreal Holding’s debt?
You can click on the graph below for historical figures, but it shows that in December 2021, Allreal Holding had debt of CHF 2.73 billion, an increase from CHF 2.18 billion, on a year. On the other hand, it has 73.4 million francs in cash, which results in a net debt of around 2.65 billion francs.
How healthy is Allreal Holding’s balance sheet?
We can see from the most recent balance sheet that Allreal Holding had liabilities of CHF 1.05 billion due in one year, and liabilities of CHF 2.19 billion due beyond. In return, it had 73.4 million Swiss francs in cash and 74.8 million Swiss francs in receivables due within 12 months. Thus, its liabilities total 3.10 billion francs more than the combination of its cash and short-term receivables.
This deficit is considerable compared to its market capitalization of CHF 3.31 billion, so he suggests that shareholders monitor the use of debt by Allreal Holding. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet quickly.
We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). Thus, we consider debt to earnings with and without amortization and depreciation expense.
Strangely, Allreal Holding has a sky-high EBITDA ratio of 14.4, implying high debt, but high interest coverage of 12.9. Either he has access to very cheap long-term debt, or his interest costs will increase! Allreal Holding increased its EBIT by 7.2% over the past year. While that barely brings us down, it’s a positive when it comes to debt. There is no doubt that we learn the most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Allreal Holding’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.
But our last consideration is also important, because a company cannot pay debt with paper profits; he needs cash. It is therefore worth checking how much of this EBIT is supported by free cash flow. Over the past three years, Allreal Holding has recorded free cash flow of 76% of its EBIT, which is about normal, given that free cash flow excludes interest and taxes. This free cash flow puts the company in a good position to repay its debt, should it arise.
Our point of view
Allreal Holding’s net debt to EBITDA was a real negative in this analysis, although the other factors we considered were considerably better. There is no doubt that its ability to cover its interest costs with its EBIT is quite flashy. Looking at all this data, we feel a bit cautious about Allreal Holding’s debt levels. While debt has its upside in higher potential returns, we think shareholders should certainly consider how debt levels might make the stock more risky. The balance sheet is clearly the area to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist outside of the balance sheet. We have identified 4 warning signs with Allreal Holding (at least 2 of which are a little nasty), and understanding them should be part of your investment process.
In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings 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 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.
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