Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from synonymous with risk.” When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. We can see that Edisun Power Europe AG (VTX:ESUN) uses debt in its business. But does this debt worry shareholders?
Why is debt risky?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. In the worst case, a company can go bankrupt if it cannot pay its creditors. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. The first step when considering a company’s debt levels is to consider its cash and debt together.
See our latest analysis for Edisun Power Europe
What is Edisun Power Europe’s debt?
The image below, which you can click on for more details, shows that in December 2021, Edisun Power Europe had a debt of CHF 287.2 million, compared to CHF 110.7 million in one year. On the other hand, it has 29.2 million francs in cash, which results in a net debt of approximately 258.0 million francs.
How strong is Edisun Power Europe’s balance sheet?
According to the last published balance sheet, Edisun Power Europe had liabilities of CHF 58.3 million at less than 12 months and liabilities of CHF 267.0 million at more than 12 months. As compensation for these obligations, it had cash of CHF 29.2 million and receivables worth CHF 9.38 million due within 12 months. It therefore has liabilities totaling 286.7 million francs more than its cash and short-term receivables, combined.
The lack here weighs heavily on the 130.5 million franc enterprise itself, as if a child is struggling under the weight of a huge backpack full of books, his sports equipment and a trumpet. . We would therefore be watching his balance sheet closely, no doubt. After all, Edisun Power Europe would probably need a major recapitalization if it had to pay its creditors today.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
Strangely, Edisun Power Europe has a sky-high EBITDA ratio of 19.8, implying high debt, but high interest coverage of 10.1. This means that unless the company has access to very cheap debt, these interest charges will likely increase in the future. Above all, Edisun Power Europe has increased its EBIT by 64% over the last twelve months, and this growth will facilitate the management of its debt. The balance sheet is clearly the area to focus on when analyzing debt. But you can’t look at debt in total isolation; because Edisun Power Europe will need income to repay this debt. So, if you want to know more about its earnings, it might be worth checking out this graph of its long-term trend.
Finally, a company can only repay its debts with cold hard cash, not with book profits. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Edisun Power Europe has burned a lot of money. While this may be the result of spending for growth, it makes debt much riskier.
Our point of view
To be frank, Edisun Power Europe’s EBIT to free cash flow conversion and its track record of keeping its total liabilities under control makes us rather uncomfortable with its level of leverage. But at least it’s decent enough to increase its EBIT; it’s encouraging. Overall, it seems to us that Edisun Power Europe’s balance sheet is really a risk for the company. We are therefore almost as suspicious of this stock as a hungry kitten of falling into its owner’s fish pond: once bitten, twice shy, as they say. 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. For example, we found 1 warning sign for Edisun Power Europe which you should be aware of before investing here.
In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.
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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.