Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. We notice that Knorr-Bremse Aktiengesellschaft (ETR:KBX) has debt on its balance sheet. But should shareholders worry about its use of debt?
Why is debt risky?
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. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. However, a more frequent (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. When we think about a company’s use of debt, we first look at cash and debt together.
Check out our latest analysis for Knorr-Bremse
What is Knorr-Bremse’s debt?
As you can see below, at the end of September 2021, Knorr-Bremse had 2.20 billion euros in debt, compared to 2.09 billion euros a year ago. Click on the image for more details. However, he also had €1.68 billion in cash, so his net debt is €517.5 million.
How healthy is Knorr-Bremse’s balance sheet?
We can see from the most recent balance sheet that Knorr-Bremse had liabilities of 3.17 billion euros due in one year, and liabilities of 2.03 billion euros due beyond. In compensation for these obligations, it had cash of 1.68 billion euros as well as receivables worth 1.55 billion euros at less than 12 months. It therefore has liabilities totaling 1.97 billion euros more than its cash and short-term receivables, combined.
Given that publicly traded Knorr-Bremse shares are worth a very impressive total of €14.0 billion, it seems unlikely that this level of liability is a major threat. That said, it is clear that we must continue to monitor its record, lest it deteriorate.
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 depreciation and amortization charges.
Knorr-Bremse has a low net debt to EBITDA ratio of just 0.46. And its EBIT easily covers its interest charges, which is 18.8 times the size. So we’re pretty relaxed about his super-conservative use of debt. And we also warmly note that Knorr-Bremse increased its EBIT by 12% last year, making its debt more manageable. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future earnings, more than anything, that will determine Knorr-Bremse’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 business needs free cash flow to pay off its debts; book profits are not enough. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Knorr-Bremse has recorded free cash flow of 66% 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
Knorr-Bremse’s interest coverage suggests he can manage his debt as easily as Cristiano Ronaldo could score a goal against an Under-14 keeper. And the good news doesn’t stop there, since its net debt to EBITDA also confirms this impression! Overall, we think Knorr-Bremse’s use of debt seems entirely reasonable and we’re not worried about that. Although debt carries risks, when used wisely, it can also generate a higher return on equity. 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. Know that Knorr-Bremse shows 1 warning sign in our investment analysis 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-neutral 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.