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. We note that AB SKF (publ) (STO:SKF B) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.
What Is AB SKF’s Debt?
As you can see below, AB SKF had kr16.4b of debt at September 2019, down from kr17.5b a year prior. However, it does have kr10.7b in cash offsetting this, leading to net debt of about kr5.76b.
A Look At AB SKF’s Liabilities
According to the last reported balance sheet, AB SKF had liabilities of kr22.0b due within 12 months, and liabilities of kr38.2b due beyond 12 months. On the other hand, it had cash of kr10.7b and kr15.1b worth of receivables due within a year. So it has liabilities totalling kr34.5b more than its cash and near-term receivables, combined.
This deficit isn’t so bad because AB SKF is worth kr82.4b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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).
AB SKF’s net debt is only 0.48 times its EBITDA. And its EBIT covers its interest expense a whopping 16.1 times over. So we’re pretty relaxed about its super-conservative use of debt. On the other hand, AB SKF’s EBIT dived 11%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 AB SKF’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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, AB SKF recorded free cash flow worth 58% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
AB SKF’s interest cover was a real positive on this analysis, as was its net debt to EBITDA. Having said that, its EBIT growth rate somewhat sensitizes us to potential future risks to the balance sheet. Considering this range of data points, we think AB SKF is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check AB SKF’s dividend history, without delay!
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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