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. 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 Atlas Copco AB (STO:ATCO A) 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 is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. 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 Net Debt?
As you can see below, at the end of September 2019, Atlas Copco had kr23.4b of debt, up from kr20.7b a year ago. Click the image for more detail. However, it also had kr13.9b in cash, and so its net debt is kr9.55b.
How Strong Is Atlas Copco’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Atlas Copco had liabilities of kr37.4b due within 12 months and liabilities of kr26.6b due beyond that. On the other hand, it had cash of kr13.9b and kr28.5b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by kr21.6b.
Of course, Atlas Copco has a titanic market capitalization of kr410.2b, 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.
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). 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).
Atlas Copco’s net debt is only 0.39 times its EBITDA. And its EBIT covers its interest expense a whopping 84.2 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Fortunately, Atlas Copco grew its EBIT by 5.7% in the last year, making that debt load look even more manageable. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Atlas Copco 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Atlas Copco produced sturdy free cash flow equating to 76% of its EBIT, about what we’d expect. 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. Over time, share prices tend to follow earnings per share, so if you’re interested in Atlas Copco, you may well want to click here to check an interactive graph of its earnings per share history.
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.
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.
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