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. 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 note that Arise AB (publ) (STO:ARISE) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Arise Carry?
As you can see below, Arise had kr877.0m of debt at June 2019, down from kr1.05b a year prior. However, it does have kr205.0m in cash offsetting this, leading to net debt of about kr672.0m.
How Strong Is Arise's Balance Sheet?
The latest balance sheet data shows that Arise had liabilities of kr135.0m due within a year, and liabilities of kr977.0m falling due after that. On the other hand, it had cash of kr205.0m and kr178.0m worth of receivables due within a year. So it has liabilities totalling kr729.0m more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of kr914.3m, so it does suggest shareholders should keep an eye on Arise's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While we wouldn't worry about Arise's net debt to EBITDA ratio of 3.6, we think its super-low interest cover of 1.0 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. The silver lining is that Arise grew its EBIT by 270% last year, which nourishing like the idealism of youth. If that earnings trend continues it will make its debt load much more manageable in the future. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Arise 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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Arise actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
Arise's interest cover was a real negative on this analysis, although the other factors we considered were considerably better There's no doubt that its ability to convert EBIT to free cash flow is pretty flash. When we consider all the elements mentioned above, it seems to us that Arise is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. We'd be motivated to research the stock further if we found out that Arise insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions 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.
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If you spot an error that warrants correction, please contact the editor at email@example.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.