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, Vesuvius plc (LON: VSVS) is in debt. But the most important question is: what risk does this debt create?
When is debt dangerous?
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. 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. That said, the most common situation is where a business manages its debt reasonably well – and to its own advantage. The first step in examining a company’s debt levels is to consider its cash flow and debt together.
See our latest analysis for Vesuvius
What is the debt of Vesuvius?
You can click on the graph below for historical figures, but it shows Vesuvius owed Â£ 310.7million in June 2021, up from Â£ 694.6million a year earlier. However, as it has a cash reserve of Â£ 162.1million, its net debt is less, at around Â£ 148.6million.
Is the balance sheet of Vesuvius healthy?
According to the latest published balance sheet, Vesuvius had liabilities of Â£ 437.3million due within 12 months and liabilities of Â£ 483.2million due beyond 12 months. In return, he had Â£ 162.1 million in cash and Â£ 412.0 million in receivables due within 12 months. Its liabilities therefore total Â£ 346.4million more than the combination of its cash and short-term receivables.
While that might sound like a lot, it’s not that big of a deal since Vesuvius has a market cap of Â£ 1.25 billion, so it could likely bolster its balance sheet by raising capital if needed. But it is clear that it is absolutely necessary to take a close look at whether it can manage its debt without dilution.
In order to measure a company’s debt relative to its profits, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its profit before interest and taxes (EBIT) divided by its interest. debtors (its interest coverage). Thus, we consider debt versus earnings with and without amortization charges.
Vesuvius has a low net debt to EBITDA ratio of just 0.92. And its EBIT easily covers its interest costs, being 14.0 times higher. We could therefore say that he is no more threatened by his debt than an elephant is by a mouse. But the other side of the story is that Vesuvius has seen its EBIT drop 8.3% in the past year. This kind of decline, if it continues, will obviously make debt more difficult to manage. The balance sheet is clearly the area you need to focus on when analyzing debt. But ultimately, the company’s future profitability will decide whether Vesuvius can strengthen its balance sheet over time. 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, Vesuvius has generated strong free cash flow equivalent to 73% of its EBIT, roughly what we expected. This hard cash allows him to reduce his debt whenever he wants.
Our point of view
The good news is that Vesuvius’ demonstrated ability to cover its interest costs with its EBIT delights us like a fluffy puppy does a toddler. But frankly, we think its EBIT growth rate undermines that impression a bit. Looking at all of the aforementioned factors together, it seems to us that Vesuvius can handle his debt quite comfortably. Of course, while this leverage can improve returns on equity, it brings more risk, so it’s worth keeping an eye out for. The balance sheet is clearly the area you need to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist off the balance sheet. For example, we discovered 1 warning sign for Vesuvius which you should know before investing here.
If you are interested in investing in companies that can generate profits without the burden of debt, check out this page free list of growing companies that have net cash on the balance sheet.
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 documents. Simply Wall St has no position in the mentioned stocks.
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