David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. We note that Evotec SE (ETR:EVT) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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.

Check out our latest analysis for Evotec

What Is Evotec's Debt?

As you can see below, at the end of June 2019, Evotec had €333.4m of debt, up from €156.5m a year ago. Click the image for more detail. However, its balance sheet shows it holds €342.3m in cash, so it actually has €8.88m net cash.

How Healthy Is Evotec's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Evotec had liabilities of €143.3m due within 12 months and liabilities of €485.2m due beyond that. Offsetting these obligations, it had cash of €342.3m as well as receivables valued at €88.8m due within 12 months. So it has liabilities totalling €197.4m more than its cash and near-term receivables, combined.

Of course, Evotec has a market capitalization of €2.94b, 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. Despite its noteworthy liabilities, Evotec boasts net cash, so it's fair to say it does not have a heavy debt load!

On top of that, Evotec grew its EBIT by 69% over the last twelve months, and that growth will make it easier to handle its debt. 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 Evotec'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Evotec may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Evotec actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing up

We could understand if investors are concerned about Evotec's liabilities, but we can be reassured by the fact it has has net cash of €8.9m. The cherry on top was that in converted 106% of that EBIT to free cash flow, bringing in €46m. So is Evotec's debt a risk? It doesn't seem so to us. Over time, share prices tend to follow earnings per share, so if you're interested in Evotec, 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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.