Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Ermenegildo Zegna N.V. (NYSE:ZGN) makes use of debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Ermenegildo Zegna's Net Debt?
The chart below, which you can click on for greater detail, shows that Ermenegildo Zegna had €388.8m in debt in June 2024; about the same as the year before. On the flip side, it has €320.7m in cash leading to net debt of about €68.1m.
How Healthy Is Ermenegildo Zegna's Balance Sheet?
According to the last reported balance sheet, Ermenegildo Zegna had liabilities of €871.5m due within 12 months, and liabilities of €995.6m due beyond 12 months. On the other hand, it had cash of €320.7m and €253.0m worth of receivables due within a year. So it has liabilities totalling €1.29b more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of €1.78b, so it does suggest shareholders should keep an eye on Ermenegildo Zegna's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While Ermenegildo Zegna's low debt to EBITDA ratio of 0.35 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.2 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Unfortunately, Ermenegildo Zegna's EBIT flopped 11% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Ermenegildo Zegna can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Ermenegildo Zegna generated free cash flow amounting to a very robust 84% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
Our View
Ermenegildo Zegna's conversion of EBIT to free cash flow was a real positive on this analysis, as was its net debt to EBITDA. Having said that, its EBIT growth rate somewhat sensitizes us to potential future risks to the balance sheet. Looking at all this data makes us feel a little cautious about Ermenegildo Zegna's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. Over time, share prices tend to follow earnings per share, so if you're interested in Ermenegildo Zegna, you may well want to click here to check an interactive graph of its earnings per share history.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.
