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 Brembo S.p.A. (BIT:BRE) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is Brembo's Net Debt?
The chart below, which you can click on for greater detail, shows that Brembo had €530.6m in debt in June 2019; about the same as the year before. However, it does have €277.6m in cash offsetting this, leading to net debt of about €253.0m.
How Healthy Is Brembo's Balance Sheet?
According to the last reported balance sheet, Brembo had liabilities of €958.0m due within 12 months, and liabilities of €484.3m due beyond 12 months. Offsetting these obligations, it had cash of €277.6m as well as receivables valued at €528.8m due within 12 months. So it has liabilities totalling €635.9m more than its cash and near-term receivables, combined.
This deficit isn't so bad because Brembo is worth €2.89b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Brembo has a low net debt to EBITDA ratio of only 0.54. And its EBIT easily covers its interest expense, being 19.3 times the size. So we're pretty relaxed about its super-conservative use of debt. On the other hand, Brembo saw its EBIT drop by 2.2% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Brembo's ability to maintain a healthy balance sheet going forward. 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. In the last three years, Brembo's free cash flow amounted to 21% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
On our analysis Brembo's interest cover should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For example, its conversion of EBIT to free cash flow makes us a little nervous about its debt. Looking at all this data makes us feel a little cautious about Brembo's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. Over time, share prices tend to follow earnings per share, so if you're interested in Brembo, you may well want to click here to check an interactive graph of its earnings per share history.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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