Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. We can see that BASF SE (ETR:BAS) uses debt in its business. But the real question is whether this debt makes the business risky.
When is debt dangerous?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. If things go really bad, lenders can take over the business. 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. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. When we look at debt levels, we first consider cash and debt levels, together.
Check out our latest analysis for BASF
What is BASF’s net debt?
The image below, which you can click on for more details, shows that BASF had debt of 17.7 billion euros at the end of December 2021, a reduction of 19.8 billion euros over one year. However, he also had €4.39 billion in cash, so his net debt is €13.3 billion.
How strong is BASF’s balance sheet?
According to the last published balance sheet, BASF had liabilities of 20.1 billion euros maturing within 12 months and liabilities of 25.2 billion euros maturing beyond 12 months. In compensation for these obligations, it had cash of 4.39 billion euros as well as receivables worth 14.3 billion euros at less than 12 months. It therefore has liabilities totaling 26.6 billion euros more than its cash and short-term receivables, combined.
BASF has a very large market capitalization of 54.1 billion euros, so it could very likely raise funds to improve its balance sheet, if the need arose. But we definitely want to keep our eyes peeled for indications that its debt is too risky.
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). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
BASF has a low net debt to EBITDA ratio of just 1.2. And its EBIT easily covers its interest costs, which is 30.4 times the size. One could therefore say that he is no more threatened by his debt than an elephant is by a mouse. Even better, BASF increased its EBIT by 141% last year, which is an impressive improvement. This boost will make it even easier to pay off debt in the future. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether BASF can strengthen its balance sheet over time. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
Finally, while the taxman may love accounting profits, lenders only accept cash. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, BASF has recorded free cash flow of 67% of its EBIT, which is about normal, given that free cash flow excludes interest and taxes. This cold hard cash allows him to reduce his debt whenever he wants.
Our point of view
The good news is that BASF’s demonstrated ability to cover its interest charges with its EBIT delights us like a fluffy puppy does a toddler. But truth be told, we think his total passive level undermines that impression a bit. Zooming out, BASF seems to be using debt quite sensibly; and that gets the green light from us. After all, reasonable leverage can increase return on equity. Another positive for shareholders is that it pays dividends. So if you like receiving those dividends, check out BASF’s dividend history now!
In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeat present.
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