Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, SAP SE (ETR:SAP) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
What Is SAP’s Net Debt?
The image below, which you can click on for greater detail, shows that at June 2020 SAP had debt of €14.9b, up from €13.8b in one year. However, because it has a cash reserve of €7.62b, its net debt is less, at about €7.30b.
A Look At SAP’s Liabilities
We can see from the most recent balance sheet that SAP had liabilities of €15.3b falling due within a year, and liabilities of €16.3b due beyond that. Offsetting these obligations, it had cash of €7.62b as well as receivables valued at €7.06b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €17.0b.
Since publicly traded SAP shares are worth a very impressive total of €158.2b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
SAP has a low net debt to EBITDA ratio of only 0.98. And its EBIT covers its interest expense a whopping 23.6 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. And we also note warmly that SAP grew its EBIT by 15% last year, making its debt load easier to handle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine SAP’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. During the last three years, SAP produced sturdy free cash flow equating to 57% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
SAP’s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. And that’s just the beginning of the good news since its net debt to EBITDA is also very heartening. Zooming out, SAP seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 1 warning sign we’ve spotted with SAP .
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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