The external fund manager, backed by Charlie Munger of Berkshire Hathaway, Li Lu, makes no bones about it when he says, “The biggest investment risk is not price volatility, but whether you will suffer permanent capital losses.” When we think about how risky a business is, we always like to look at the use of debt, as over-indebtedness can lead to ruin. As with many other companies Hera SpA (HER BITTEN) takes advantage of debt. But is this debt a concern for shareholders?
When is debt dangerous?
Debt is a tool to help companies grow, but if a company is unable to pay off its lenders, it is at their mercy. If the company can’t meet its legal obligations to repay debt, shareholders may end up walking away with nothing. While not too common, we often see indebted companies permanently diluting their shareholders as lenders force them to raise capital at a difficult price. Debt can, of course, be an important tool in companies, especially in wealthy companies. When we examine debt levels, we first look at both cash and debt levels together.
Check out our latest analysis for Hera
What is Hera’s fault?
As you can see below, at the end of March 2021, Hera had €4.37 billion in debt, up from €3.90 billion years ago. Click on the image for more details. However, since it has a cash reserve of €1.23 billion, its net debt is less at around €3.14 billion.
How healthy is Hera’s balance sheet?
From the most recent balance sheet, we can see that Hera had debts of €3.63 billion that fell due within one year, and liabilities of €4.51 billion that had to be paid afterwards. On the other hand, it had €1.23 billion in cash and €2.20 billion in receivables to be paid within a year. It therefore has a total of €4.71 billion more liabilities than its cash and short-term receivables combined.
This is a huge leverage against the market cap of €5.04 billion. This suggests that shareholders would be highly diluted if the company had to strengthen its balance sheet quickly.
To upgrade a company’s debt relative to revenue, we calculate net debt divided by revenue before interest, taxes, depreciation, and amortization (EBITDA) and revenue before interest and tax (EBIT) divided by interest expense (are interest coverage). In this way, we take into account both the absolute amount of the debt and the interest rates paid on it.
Hera has a debt-to-EBITDA ratio of 3.3, indicating significant debt, but still reasonable for most types of businesses. But EBIT was about 11.9 times the cost of interest, which means the company isn’t paying a really high cost to maintain that level of debt. Even if the low cost proves unsustainable, that’s a good sign. Importantly, Hera’s EBIT has been virtually flat over the past 12 months. Ideally, it can reduce its debt burden by triggering earnings growth. When analyzing debt levels, the balance sheet is the obvious place to start. But it is mainly future income that will determine Hera’s ability to maintain a healthy balance sheet in the future. So if you want to see what the pros think, you might find this free analyst earnings forecast report be interesting.
Finally, while the tax man loves accounting profits, lenders only accept cold hard cash. So the logical step is to look at the portion of that EBIT that is matched by actual free cash flow. Over the past three years, Hera recorded free cash flow equal to 54% of its EBIT, which is about normal as the free cash flow excludes interest and taxes. This free cash flow puts the company in a good position to pay off debt if necessary.
Hera’s level of total liabilities and net debt to EBITDA certainly weighs in our valuation. But the interest rate cover tells a very different story and suggests some resilience. It’s also worth noting that Hera is in the Integrated Utilities industry, which is often considered quite defensive. Looking at all the angles mentioned above, it seems to us that Hera is a somewhat risky investment due to its debt. Not all risk is bad, as it can increase equity returns when it pays off, but this debt risk is worth bearing in mind. When analyzing debt levels, the balance sheet is the obvious place to start. However, not all investment risks reside within the balance sheet – far from it. Example: we’ve seen it 1 warning sign for Hera you must be aware.
If you are interested in investing in companies that can make profits without debt, check this out free list of growing companies with net cash on the balance sheet.
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This article from Simply Wall St is general in nature. It is not a recommendation to buy or sell stocks and does not take into account your objectives or your financial situation. We strive to provide you with long-term focused analysis powered by fundamental data. Please note that our analysis may not take into account the latest price-sensitive company announcements or quality material. Simply Wall St has no position in said stocks.
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The post We think Hera (BIT:HER) is taking some risk with his debt appeared first on Notesradar.
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