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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that SAP SE (FRA:SAP) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is SAP's Net Debt?
You can click the graphic below for the historical numbers, but it shows that SAP had €1.46b of debt in June 2019, down from €7.68b, one year before. However, its balance sheet shows it holds €5.57b in cash, so it actually has €4.11b net cash.
A Look At SAP's Liabilities
Zooming in on the latest balance sheet data, we can see that SAP had liabilities of €14.2b due within 12 months and liabilities of €15.9b due beyond that. On the other hand, it had cash of €5.57b and €6.77b worth of receivables due within a year. So its liabilities total €17.7b more than the combination of its cash and short-term receivables.
Of course, SAP has a titanic market capitalization of €129.2b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, SAP also has more cash than debt, so we're pretty confident it can manage its debt safely.
Fortunately, SAP grew its EBIT by 2.7% in the last year, making that debt load look even more manageable. There's no doubt that we learn most about debt from the balance sheet. 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're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While SAP has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the most recent three years, SAP recorded free cash flow worth 63% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Although SAP's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of €4.1b. So we don't have any problem with SAP's use of debt. Over time, share prices tend to follow earnings per share, so if you're interested in SAP, you may well want to click here to check an interactive graph of its earnings per share history.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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