Legendary fund manager Li Lu (who was backed by Charlie Munger) once said, “The biggest investment risk isn’t the volatility of prices, it’s whether you suffer a permanent loss of capital.” When we think about how risky a company is, we always look gladly on the use of debt, as over-indebtedness can lead to ruin. Important, AB SKF (Ed.) (STO:SKF B) is in debt. But the more important question is: How much risk does this debt carry?
When is debt dangerous?
Debt and other liabilities become risky for a company when it cannot easily meet those obligations, either through free cash flow or by raising capital at an attractive rate. Ultimately, if the company fails to meet its legal obligations to pay down debt, shareholders could get away with nothing. While this isn’t all that common, we often see leveraged companies permanently diluting shareholders as lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, especially capital-intensive ones. When thinking about a company’s use of debt, let’s first consider cash and debt together.
What is AB SKF’s debt?
As you can see below, AB SKF had debts of kr 15.8 billion in December 2020, which is about the same as last year. You can click on the chart to see more details. However, since it has a cash reserve of kr14.6bn, its net debt is lower at about kr1.13bn.
A look at AB SKF’s liabilities
The latest balance sheet data shows that AB SKF had liabilities due within one year of kr21.6 billion and liabilities due thereafter of kr33.2 billion. To offset these obligations, it had cash on hand of DKK 14.6 billion and accounts receivable worth DKK 15.9 billion that were due within 12 months. Therefore, its liabilities exceed the sum of its cash and (short-term) receivables by 24.3 billion kr.
AB SKF has a very large market capitalization of kr114.6bn, so it could very likely raise cash to improve its balance sheet if the need arose. But we definitely want to keep our eyes peeled for signs his debt carries too much risk. Because AB SKF has virtually no net debt, it actually has a very low debt burden.
To estimate a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its earnings before interest and taxes (EBIT) divided by its interest expense (its interest coverage). In this way, we take into account both the absolute amount of the debt and the interest paid on it.
AB SKF has a low net debt to EBITDA ratio of just 0.12. And its EBIT, at 30.6 times, easily covers its interest expenses. So you could argue that it’s no more threatened by its debt than an elephant is by a mouse. In fact, AB SKF’s salvation is low debt, with EBIT falling 27% over the last 12 months. When it comes to paying off debt, falling earnings are no more beneficial to your health than sugary sodas. When analyzing debt, the balance sheet is the obvious place to start. But ultimately, the company’s future profitability will determine whether AB SKF can strengthen its balance sheet over time. So if you want to see what the experts think, you might find it this free analyst earnings forecast report to be interesting.
After all, a business needs free cash flow to pay off debt; Accounting profits just don’t cut it. So we always check how much of that EBIT translates into free cash flow. Over the past three years, AB SKF has reported free cash flow equivalent to 65% of its EBIT, which is about normal given that free cash flow excludes interest and taxes. This cold, hard money means they can reduce their debt whenever they want.
AB SKF’s EBIT growth rate was actually negative in this analysis, although the other factors we considered were significantly better. There’s no doubt that its ability to cover its interest expense with its EBIT is quite striking. Given this range of data points, we think AB SKF is in a good position to control its leverage. But a word of caution: we think the level of debt is high enough to warrant continued monitoring. When analyzing debt, the balance sheet is the obvious place to start. But ultimately, every business can have off-balance-sheet risks. Note that AB SKF shows 2 warning signs in our investment analysis you should know that…
After all this, if you’re more interested in a fast-growing company with a rock-solid balance sheet, then look no further our list of net cash growth stocks without delay.
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