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. Importantly, AB Fagerhult (STO:FAG) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does AB Fagerhult Carry?
As you can see below, at the end of June 2019, AB Fagerhult had kr4.39b of debt, up from kr3.16b a year ago. Click the image for more detail. However, it also had kr989.1m in cash, and so its net debt is kr3.40b.
How Strong Is AB Fagerhult's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that AB Fagerhult had liabilities of kr2.02b due within 12 months and liabilities of kr5.99b due beyond that. On the other hand, it had cash of kr989.1m and kr1.56b worth of receivables due within a year. So its liabilities total kr5.46b more than the combination of its cash and short-term receivables.
This deficit isn't so bad because AB Fagerhult is worth kr9.86b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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.
AB Fagerhult's net debt is 3.6 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 10.7 times its interest expense, implying the company isn't really paying full freight on that debt. Even if not sustainable, that is a good sign. AB Fagerhult grew its EBIT by 8.4% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if AB Fagerhult can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, AB Fagerhult produced sturdy free cash flow equating to 53% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
On our analysis AB Fagerhult's interest cover should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For example, its net debt to EBITDA makes us a little nervous about its debt. When we consider all the factors mentioned above, we do feel a bit cautious about AB Fagerhult's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. We'd be motivated to research the stock further if we found out that AB Fagerhult 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.
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.
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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.