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’. 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 can see that Alfa Laval AB (publ) (STO:ALFA) does use debt in its business. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Alfa Laval’s Debt?
The image below, which you can click on for greater detail, shows that Alfa Laval had debt of kr10.8b at the end of March 2020, a reduction from kr12.0b over a year. However, because it has a cash reserve of kr5.00b, its net debt is less, at about kr5.79b.
How Strong Is Alfa Laval’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Alfa Laval had liabilities of kr21.1b due within 12 months and liabilities of kr16.4b due beyond that. Offsetting these obligations, it had cash of kr5.00b as well as receivables valued at kr13.1b due within 12 months. So its liabilities total kr19.5b more than the combination of its cash and short-term receivables.
Alfa Laval has a market capitalization of kr85.7b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution.
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).
Alfa Laval has a low net debt to EBITDA ratio of only 0.67. And its EBIT easily covers its interest expense, being 44.1 times the size. So we’re pretty relaxed about its super-conservative use of debt. Another good sign is that Alfa Laval has been able to increase its EBIT by 21% in twelve months, making it easier to pay down debt. 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 Alfa Laval 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Alfa Laval recorded free cash flow worth 63% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Happily, Alfa Laval’s impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its EBIT growth rate also supports that impression! Looking at the bigger picture, we think Alfa Laval’s use of debt seems quite reasonable and we’re not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider risks, for instance. Every company has them, and we’ve spotted 1 warning sign for Alfa Laval you should know about.
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.
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