Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that MERCK Kommanditgesellschaft auf Aktien (FRA:MRK) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is MERCK Kommanditgesellschaft auf Aktien's Net Debt?
As you can see below, MERCK Kommanditgesellschaft auf Aktien had €11.0b of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, because it has a cash reserve of €3.61b, its net debt is less, at about €7.40b.
A Look At MERCK Kommanditgesellschaft auf Aktien's Liabilities
According to the last reported balance sheet, MERCK Kommanditgesellschaft auf Aktien had liabilities of €10.5b due within 12 months, and liabilities of €11.5b due beyond 12 months. On the other hand, it had cash of €3.61b and €3.77b worth of receivables due within a year. So it has liabilities totalling €14.6b more than its cash and near-term receivables, combined.
MERCK Kommanditgesellschaft auf Aktien has a very large market capitalization of €41.4b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
MERCK Kommanditgesellschaft auf Aktien's net debt of 2.0 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 8.6 times its interest expenses harmonizes with that theme. Unfortunately, MERCK Kommanditgesellschaft auf Aktien saw its EBIT slide 4.3% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if MERCK Kommanditgesellschaft auf Aktien can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, MERCK Kommanditgesellschaft auf Aktien recorded free cash flow worth 80% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
On our analysis MERCK Kommanditgesellschaft auf Aktien's conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For example, its EBIT growth rate makes us a little nervous about its debt. When we consider all the elements mentioned above, it seems to us that MERCK Kommanditgesellschaft auf Aktien is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. Over time, share prices tend to follow earnings per share, so if you're interested in MERCK Kommanditgesellschaft auf Aktien, you may well want to click here to check an interactive graph of its earnings per share history.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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