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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Gunnebo AB (publ) (STO:GUNN) does carry debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Gunnebo's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Gunnebo had kr2.00b of debt, an increase on kr1.68b, over one year. However, it does have kr569.0m in cash offsetting this, leading to net debt of about kr1.44b.
A Look At Gunnebo's Liabilities
Zooming in on the latest balance sheet data, we can see that Gunnebo had liabilities of kr1.58b due within 12 months and liabilities of kr2.47b due beyond that. On the other hand, it had cash of kr569.0m and kr955.0m worth of receivables due within a year. So its liabilities total kr2.53b more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company's kr1.79b market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner's social media. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Gunnebo has a debt to EBITDA ratio of 4.1 and its EBIT covered its interest expense 5.8 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Unfortunately, Gunnebo saw its EBIT slide 6.4% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. 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 Gunnebo's ability to maintain a healthy balance sheet going forward. 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 it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Gunnebo created free cash flow amounting to 14% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.
Mulling over Gunnebo's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. Having said that, its ability to cover its interest expense with its EBIT isn't such a worry. We're quite clear that we consider Gunnebo to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. Given our concerns about Gunnebo's debt levels, it seems only prudent to check if insiders have been ditching the stock.
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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