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Does Continental (ETR:CON) Have A Healthy Balance Sheet?

Simply Wall St

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Continental Aktiengesellschaft (ETR:CON) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Continental

How Much Debt Does Continental Carry?

As you can see below, at the end of June 2019, Continental had €5.92b of debt, up from €5.15b a year ago. Click the image for more detail. However, because it has a cash reserve of €1.91b, its net debt is less, at about €4.02b.

XTRA:CON Historical Debt, October 21st 2019

A Look At Continental's Liabilities

The latest balance sheet data shows that Continental had liabilities of €17.1b due within a year, and liabilities of €8.73b falling due after that. On the other hand, it had cash of €1.91b and €8.88b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €15.0b.

This is a mountain of leverage even relative to its gargantuan market capitalization of €23.5b. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Continental's net debt is only 0.97 times its EBITDA. And its EBIT easily covers its interest expense, being 25.3 times the size. So we're pretty relaxed about its super-conservative use of debt. The modesty of its debt load may become crucial for Continental if management cannot prevent a repeat of the 51% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Continental can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Continental recorded free cash flow of 50% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Neither Continental's ability to grow its EBIT nor its level of total liabilities gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Continental's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Continental's dividend history, without delay!

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.