Is Gerresheimer (ETR: GXI) a risky investment?
Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say “The biggest risk in investing is not price volatility, but the fact that you suffer a permanent loss of capital. “. When we think about how risky a business is, we always like to look at its use of debt because debt overload can lead to bankruptcy. Mostly, Gerresheimer AG (ETR: GXI) carries the debt. But the real question is whether this debt makes the business risky.
When is debt a problem?
Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. However, a more common (but still costly) situation is where a company has to dilute its shareholders at a cheap share price just to get its debt under control. Of course, many companies use debt to finance their growth without negative consequences. The first step in examining a company’s debt levels is to consider its cash flow and debt together.
See our latest analysis for Gerresheimer
What is Gerresheimer’s debt?
As you can see below, Gerresheimer had 1.05 billion euros in debt, as of February 2021, which is roughly the same as the year before. You can click on the graph for more details. However, because it has a cash reserve of € 92.4 million, its net debt is lower, at around € 962.6 million.
How strong is Gerresheimer’s balance sheet?
The latest balance sheet data shows Gerresheimer had debt of € 573.9 million maturing within one year and debts of € 1.13 billion maturing thereafter. In return, he had € 92.4 million in cash and € 240.4 million in receivables due within 12 months. Its liabilities therefore amount to € 1.37 billion more than the combination of its cash and short-term receivables.
This deficit is not that bad as Gerresheimer is worth 2.93 billion euros, and could therefore probably raise enough capital to consolidate his balance sheet, should the need arise. But it is clear that it is absolutely necessary to take a close look at whether it can manage its debt without dilution.
In order to measure a company’s debt relative to its profits, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its profit before interest and taxes (EBIT) divided by its interest. debtors (its interest coverage). Thus, we consider debt versus earnings with and without amortization charges.
With a net debt on EBITDA of 3.2 Gerresheimer has a fairly significant debt. But the high interest coverage of 8.2 suggests that he can easily pay off that debt. Importantly, Gerresheimer has increased its EBIT by 45% over the past twelve months, and this growth will make it easier to process its debt. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether Gerresheimer can strengthen its balance sheet over time. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
Finally, a business can only pay off its debts with hard cash, not with book profits. We must therefore clearly check whether this EBIT generates a corresponding free cash flow. Over the past three years, Gerresheimer has recorded free cash flow of 21% of its EBIT, which is lower than expected. This low cash conversion makes debt management more difficult.
Our point of view
When it comes to the balance sheet, the main positive for Gerresheimer was the fact that he seems able to increase his EBIT with confidence. But the other factors we noted above weren’t so encouraging. For example, its conversion from EBIT to free cash flow makes us a little nervous about its debt. When we consider all of the factors mentioned above, we feel a little cautious about Gerresheimer’s use of debt. While we understand that debt can improve returns on equity, we suggest shareholders watch their debt level closely, lest they increase. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks lie on the balance sheet – far from it. For example, we discovered 1 warning sign for Gerresheimer which you should know before investing here.
If you are interested in investing in companies that can generate profits without the burden of debt, check out this page free list of growing companies that have net cash on the balance sheet.
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