Stock Analysis

BKW (VTX:BKW) Takes On Some Risk With Its Use Of Debt

SWX:BKW
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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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that BKW AG (VTX:BKW) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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. When we examine debt levels, we first consider both cash and debt levels, together.

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What Is BKW's Net Debt?

The chart below, which you can click on for greater detail, shows that BKW had CHF1.90b in debt in June 2024; about the same as the year before. However, it does have CHF768.0m in cash offsetting this, leading to net debt of about CHF1.13b.

debt-equity-history-analysis
SWX:BKW Debt to Equity History September 13th 2024

A Look At BKW's Liabilities

We can see from the most recent balance sheet that BKW had liabilities of CHF1.89b falling due within a year, and liabilities of CHF3.89b due beyond that. Offsetting this, it had CHF768.0m in cash and CHF1.28b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CHF3.73b.

While this might seem like a lot, it is not so bad since BKW has a market capitalization of CHF8.13b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).

BKW's net debt is only 1.2 times its EBITDA. And its EBIT covers its interest expense a whopping 11.5 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In fact BKW's saving grace is its low debt levels, because its EBIT has tanked 34% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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 BKW'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, BKW recorded free cash flow of 25% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

BKW's EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example its interest cover was refreshing. It's also worth noting that BKW is in the Electric Utilities industry, which is often considered to be quite defensive. When we consider all the factors discussed, it seems to us that BKW is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. To that end, you should be aware of the 2 warning signs we've spotted with BKW .

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.

Valuation is complex, but we're here to simplify it.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.