Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from synonymous with risk.” When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. Above all, Metro SA (ETR:B4B) is in debt. But should shareholders worry about its use of debt?
When is debt dangerous?
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) event is when a company has to issue shares at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. The first thing to do when considering how much debt a business has is to look at its cash and debt together.
Check out our latest analysis for Metro
What is Metro’s debt?
The image below, which you can click on for more details, shows that Metro had a debt of 4.68 billion euros at the end of March 2022, a reduction of 5.48 billion euros over one year. However, he also had 791.0 million euros in cash, and his net debt is therefore 3.89 billion euros.
How strong is Metro’s balance sheet?
According to the last published balance sheet, Metro had liabilities of 6.64 billion euros maturing within 12 months and liabilities of 3.89 billion euros maturing beyond 12 months. On the other hand, it has cash of €791.0 million and €580.0 million in receivables at less than one year. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables by €9.16 billion.
The deficiency here weighs heavily on the company itself of 2.97 billion euros, like a child struggling under the weight of a huge backpack full of books, his sports equipment and a trumpet. We would therefore be watching his balance sheet closely, no doubt. Ultimately, Metro would likely need a major recapitalization if its creditors were to demand repayment.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
While we’re not concerned about Metro’s net debt to EBITDA ratio of 4.6, we believe its extremely low interest coverage of 2.1x is a sign of high leverage. It looks like the company is incurring significant amortization and amortization costs, so perhaps its leverage is heavier than it first appears, since EBITDA is arguably a generous metric benefits. It seems clear that the cost of borrowing money is having a negative impact on shareholder returns lately. On the bright side, Metro has grown its EBIT by 79% over the past year. Like the milk of human kindness, this type of growth increases resilience, making the business more capable of managing debt. When analyzing debt levels, the balance sheet is the obvious starting point. But it’s future earnings, more than anything, that will determine Metro’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.
Finally, a company can only repay its debts with cold hard cash, not with book profits. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Metro has actually produced more free cash flow than EBIT. There’s nothing better than cash coming in to stay in your lenders’ good books.
Our point of view
We feel some trepidation about Metro’s total passive difficulty level, but we also have some positives to focus on. The EBIT to free cash flow conversion and the EBIT growth rate were encouraging signs. Considering the above factors, we believe that Metro’s debt poses certain risks to the business. While this debt may increase returns, we believe the company now has sufficient leverage. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks reside on the balance sheet, far from it. For example – Metro a 1 warning sign we think you should know.
If, after all that, you’re more interested in a fast-growing company with a strong balance sheet, check out our list of cash-flowing growth stocks right away.
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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.