Does Merck KGaA (ETR:MRK) Have A Healthy Balance Sheet?

Simply Wall St · 10/10/2023 04:02

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 can see that Merck KGaA (ETR:MRK) does use debt in its business. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Merck KGaA

How Much Debt Does Merck KGaA Carry?

As you can see below, Merck KGaA had €10.7b of debt at June 2023, down from €11.3b a year prior. However, because it has a cash reserve of €1.93b, its net debt is less, at about €8.78b.

debt-equity-history-analysis
XTRA:MRK Debt to Equity History October 10th 2023

A Look At Merck KGaA's Liabilities

According to the last reported balance sheet, Merck KGaA had liabilities of €8.85b due within 12 months, and liabilities of €13.2b due beyond 12 months. On the other hand, it had cash of €1.93b and €4.85b worth of receivables due within a year. So its liabilities total €15.2b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Merck KGaA has a huge market capitalization of €67.4b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Merck KGaA has a low net debt to EBITDA ratio of only 1.4. And its EBIT covers its interest expense a whopping 35.1 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The good news is that Merck KGaA has increased its EBIT by 4.1% over twelve months, which should ease any concerns about debt repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Merck KGaA'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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Merck KGaA recorded free cash flow worth 60% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

The good news is that Merck KGaA's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And we also thought its conversion of EBIT to free cash flow was a positive. Looking at all the aforementioned factors together, it strikes us that Merck KGaA can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Merck KGaA's earnings per share history for free.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.