The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Atlas Copco AB (STO:ATCO A) makes use of debt. But the real question is whether this debt is making the company risky.
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Atlas Copco's Debt?
The image below, which you can click on for greater detail, shows that Atlas Copco had debt of kr19.5b at the end of June 2019, a reduction from kr21.0b over a year. However, because it has a cash reserve of kr11.8b, its net debt is less, at about kr7.64b.
How Healthy Is Atlas Copco's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Atlas Copco had liabilities of kr35.6b due within 12 months and liabilities of kr22.7b due beyond that. Offsetting this, it had kr11.8b in cash and kr27.4b in receivables that were due within 12 months. So its liabilities total kr19.0b more than the combination of its cash and short-term receivables.
Since publicly traded Atlas Copco shares are worth a very impressive total of kr315.3b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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.
Atlas Copco's net debt is only 0.32 times its EBITDA. And its EBIT covers its interest expense a whopping 73.4 times over. So we're pretty relaxed about its super-conservative use of debt. The good news is that Atlas Copco has increased its EBIT by 4.2% over twelve months, which should ease any concerns about debt repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Atlas Copco'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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Atlas Copco recorded free cash flow worth 78% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Atlas Copco's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Looking at the bigger picture, we think Atlas Copco's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. We'd be motivated to research the stock further if we found out that Atlas Copco 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.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.