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 EssilorLuxottica Société anonyme (EPA:EL) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is EssilorLuxottica Société anonyme's Debt?
As you can see below, at the end of June 2019, EssilorLuxottica Société anonyme had €4.34b of debt, up from €2.52b a year ago. Click the image for more detail. On the flip side, it has €1.54b in cash leading to net debt of about €2.80b.
How Healthy Is EssilorLuxottica Société anonyme's Balance Sheet?
We can see from the most recent balance sheet that EssilorLuxottica Société anonyme had liabilities of €6.78b falling due within a year, and liabilities of €7.12b due beyond that. Offsetting this, it had €1.54b in cash and €2.71b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €9.65b.
Since publicly traded EssilorLuxottica Société anonyme shares are worth a very impressive total of €57.0b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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.
EssilorLuxottica Société anonyme has a low net debt to EBITDA ratio of only 0.91. And its EBIT easily covers its interest expense, being 25.4 times the size. So we're pretty relaxed about its super-conservative use of debt. On the other hand, EssilorLuxottica Société anonyme saw its EBIT drop by 8.7% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine EssilorLuxottica Société anonyme's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, EssilorLuxottica Société anonyme recorded free cash flow worth 75% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
The good news is that EssilorLuxottica Société anonyme's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its EBIT growth rate. All these things considered, it appears that EssilorLuxottica Société anonyme can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of EssilorLuxottica Société anonyme's earnings per share history for free.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.