These 4 measures indicate that Rheinmetall (ETR:RHM) is using its debt reasonably well

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Warren Buffett said: “Volatility is far from synonymous with risk. So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. Like many other companies Rheinmetall AG (ETR:RHM) uses debt. But should shareholders worry about its use of debt?

When is debt a problem?

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. However, a more usual (but still expensive) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. 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 think about a company’s use of debt, we first look at cash and debt together.

See our latest analysis for Rheinmetall

What is Rheinmetall’s debt?

You can click on the chart below for historical numbers, but it shows Rheinmetall had €953.0 million in debt in September 2021, up from €1.26 billion a year earlier. However, because it has a cash reserve of €718.0 million, its net debt is lower, at around €235.0 million.

XTRA: RHM Debt to Equity January 15, 2022

How strong is Rheinmetall’s balance sheet?

According to the last published balance sheet, Rheinmetall had liabilities of 3.22 billion euros due within 12 months and liabilities of 1.79 billion euros due beyond 12 months. On the other hand, it had cash of €718.0 million and €1.63 billion in receivables at less than one year. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables by €2.66 billion.

That’s a mountain of leverage compared to its market capitalization of 3.97 billion euros. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet quickly.

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.

Rheinmetall has a low net debt to EBITDA ratio of just 0.44. And its EBIT easily covers its interest costs, which is 16.0 times the size. So we’re pretty relaxed about his super-conservative use of debt. Another good thing is that Rheinmetall increased its EBIT by 15% over the past year, further increasing its ability to manage debt. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether Rheinmetall 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, 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, Rheinmetall has recorded free cash flow of 65% 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

Fortunately, Rheinmetall’s impressive interest coverage means it has the upper hand on its debt. But truth be told, we think his total passive level undermines that impression a bit. All in all, it looks like Rheinmetall can comfortably manage its current level of debt. On the plus side, this leverage can increase shareholder returns, but the potential downside is more risk of loss, so it’s worth keeping an eye on the balance sheet. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks reside on the balance sheet, far from it. We have identified 3 warning signs with Rheinmetall, and understanding them should be part of your investment process.

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% free, at present.

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.

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