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 Indutrade AB (publ) (STO:INDT) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Indutrade Carry?
As you can see below, at the end of December 2019, Indutrade had kr6.36b of debt, up from kr4.21b a year ago. Click the image for more detail. However, because it has a cash reserve of kr719.0m, its net debt is less, at about kr5.65b.
How Healthy Is Indutrade’s Balance Sheet?
We can see from the most recent balance sheet that Indutrade had liabilities of kr4.95b falling due within a year, and liabilities of kr5.43b due beyond that. Offsetting these obligations, it had cash of kr719.0m as well as receivables valued at kr3.54b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by kr6.12b.
Given Indutrade has a market capitalization of kr37.5b, it’s hard to believe these liabilities pose much 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.
Indutrade’s net debt to EBITDA ratio of about 2.2 suggests only moderate use of debt. And its commanding EBIT of 16.1 times its interest expense, implies the debt load is as light as a peacock feather. If Indutrade can keep growing EBIT at last year’s rate of 11% over the last year, then it will find its debt load easier to manage. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Indutrade 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. During the last three years, Indutrade produced sturdy free cash flow equating to 74% 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.
Happily, Indutrade’s impressive interest cover implies it has the upper hand on its debt. And that’s just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. When we consider the range of factors above, it looks like Indutrade is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We’ve identified 1 warning sign with Indutrade , and understanding them should be part of your investment process.
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.
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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