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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Projektengagemang Sweden AB (publ) (STO:PENG B) does use debt in its business. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Projektengagemang Sweden Carry?
As you can see below, at the end of June 2019, Projektengagemang Sweden had kr404.4m of debt, up from kr200.0m a year ago. Click the image for more detail. However, it also had kr56.1m in cash, and so its net debt is kr348.3m.
How Strong Is Projektengagemang Sweden's Balance Sheet?
According to the last reported balance sheet, Projektengagemang Sweden had liabilities of kr380.5m due within 12 months, and liabilities of kr359.5m due beyond 12 months. Offsetting these obligations, it had cash of kr56.1m as well as receivables valued at kr364.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by kr319.7m.
While this might seem like a lot, it is not so bad since Projektengagemang Sweden has a market capitalization of kr584.4m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With net debt to EBITDA of 3.7 Projektengagemang Sweden has a fairly noticeable amount of debt. On the plus side, its EBIT was 7.9 times its interest expense, and its net debt to EBITDA, was quite high, at 3.7. Shareholders should be aware that Projektengagemang Sweden's EBIT was down 29% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But it is Projektengagemang Sweden's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Projektengagemang Sweden produced sturdy free cash flow equating to 66% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Projektengagemang Sweden's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example its conversion of EBIT to free cash flow was refreshing. When we consider all the factors discussed, it seems to us that Projektengagemang Sweden is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. Given our hesitation about the stock, it would be good to know if Projektengagemang Sweden insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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.
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