Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk’. 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. We can see that Arcoma AB (STO:ARCOMA) does use debt in its business. But is this debt a concern to shareholders?
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. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does Arcoma Carry?
The image below, which you can click on for greater detail, shows that at March 2020 Arcoma had debt of kr14.4m, up from kr8.96m in one year. However, it does have kr9.69m in cash offsetting this, leading to net debt of about kr4.71m.
How Healthy Is Arcoma’s Balance Sheet?
The latest balance sheet data shows that Arcoma had liabilities of kr47.7m due within a year, and liabilities of kr368.0k falling due after that. Offsetting these obligations, it had cash of kr9.69m as well as receivables valued at kr26.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by kr11.7m.
Of course, Arcoma has a market capitalization of kr239.6m, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Arcoma has a low net debt to EBITDA ratio of only 0.34. And its EBIT easily covers its interest expense, being 24.2 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Even more impressive was the fact that Arcoma grew its EBIT by 500% over twelve months. That boost will make it even easier to pay down debt going forward. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Arcoma 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 it’s worth checking how much of that EBIT is backed by free cash flow. In the last two years, Arcoma’s free cash flow amounted to 21% of its EBIT, less than we’d expect. That’s not great, when it comes to paying down debt.
The good news is that Arcoma’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. It’s also worth noting that Arcoma is in the Medical Equipment industry, which is often considered to be quite defensive. Looking at the bigger picture, we think Arcoma’s use of debt seems quite reasonable and we’re not concerned about it. After all, sensible leverage can boost returns on equity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we’ve discovered 1 warning sign for Arcoma that you should be aware of before investing here.
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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