Legendary fund manager Li Lu (whom Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but the possibility that you will suffer a permanent loss of capital. It is only natural to consider a company’s balance sheet when looking at its level of risk, as debt is often involved when a business collapses. Like many other companies Brembo SpA (BIT: BRE) uses debt. But should shareholders be concerned about its use of debt?
What risk does debt entail?
Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. If things really go wrong, lenders can take over the business. While it’s not too common, we often see indebted companies continually diluting their shareholders because lenders are forcing them to raise capital at a ridiculous price. That said, the most common situation is where a business manages its debt reasonably well – and to its own advantage. The first step in examining a company’s debt levels is to consider its cash flow and debt together.
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How much debt does Brembo have?
The image below, which you can click for more details, shows that in March 2021, Brembo had a debt of 743.9 million euros, up from 485.0 million euros in a year. On the other hand, it has 514.7 million euros in cash, leading to a net debt of approximately 229.1 million euros.
Is Brembo’s track record healthy?
According to the latest published balance sheet, Brembo had liabilities of 906.8 million euros less than 12 months and liabilities of 839.6 million euros over 12 months. In compensation for these obligations, he had cash of € 514.7 million as well as receivables valued at € 587.3 million maturing in 12 months. Its liabilities thus exceed the sum of its cash and its receivables (short term) by € 644.4 million.
Given that Brembo has a market capitalization of 3.44 billion euros, it’s hard to believe that these liabilities pose a significant threat. However, we think it’s worth keeping an eye on the strength of its balance sheet as it can change over time.
We measure a company’s debt load relative to its earning capacity by looking at its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT) covers its interest costs (interest coverage). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt versus EBITDA) and the actual interest charges associated with this debt (with its coverage rate). interests).
Brembo has a low net debt to EBITDA ratio of just 0.62. And its EBIT covers its interest costs 15.6 times more. We could therefore say that he is no more threatened by his debt than an elephant is by a mouse. The modesty of its leverage may become crucial for Brembo if management cannot prevent a repeat of the 25% reduction in EBIT over the past year. When a business sees its profits accumulate, it can sometimes see its relationship with its lenders deteriorate. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether Brembo 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.
But our last consideration is also important, because a business cannot pay its debts with paper profits; he needs hard cash. The logical step is therefore to examine the proportion of this EBIT that corresponds to the actual free cash flow. Over the past three years, Brembo has generated strong free cash flow equivalent to 51% of its EBIT, roughly what we expected. This free cash flow puts the business in a good position to repay debt, if any.
Our point of view
Brembo’s EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are blown away by its coverage of interest. Looking at all of this data, we feel a little cautious about Brembo’s debt levels. While we understand that debt can improve returns on equity, we suggest shareholders watch their debt level closely, lest they increase. The balance sheet is clearly the area you need to focus on when analyzing debt. However, not all investment risks lie on the balance sheet – far from it. For example – Brembo has 2 warning signs we think you should be aware.
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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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in any of the stocks mentioned.
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