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Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Ercros, S.A. (BME:ECR) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
View our latest analysis for Ercros
What Is Ercros's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Ercros had debt of €168.3m, up from €118.0m in one year. However, it does have €39.6m in cash offsetting this, leading to net debt of about €128.7m.
How Healthy Is Ercros's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Ercros had liabilities of €252.8m due within 12 months and liabilities of €128.4m due beyond that. Offsetting these obligations, it had cash of €39.6m as well as receivables valued at €124.1m due within 12 months. So its liabilities total €217.5m more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of €227.9m, so it does suggest shareholders should keep an eye on Ercros's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).