Is Brødrene A & O Johansen (CPH:AOJ B) A Risky Investment?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Brødrene A & O Johansen A/S (CPH:AOJ B) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Brødrene A & O Johansen

What Is Brødrene A & O Johansen's Debt?

As you can see below, Brødrene A & O Johansen had kr.668.4m of debt, at September 2023, which is about the same as the year before. You can click the chart for greater detail. Net debt is about the same, since the it doesn't have much cash.

How Strong Is Brødrene A & O Johansen's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Brødrene A & O Johansen had liabilities of kr.1.32b due within 12 months and liabilities of kr.527.7m due beyond that. Offsetting these obligations, it had cash of kr.332.0k as well as receivables valued at kr.671.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by kr.1.17b.

This deficit is considerable relative to its market capitalization of kr.1.69b, so it does suggest shareholders should keep an eye on Brødrene A & O Johansen's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

We'd say that Brødrene A & O Johansen's moderate net debt to EBITDA ratio ( being 1.7), indicates prudence when it comes to debt. And its strong interest cover of 12.6 times, makes us even more comfortable. On the other hand, Brødrene A & O Johansen saw its EBIT drop by 4.3% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Brødrene A & O Johansen will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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. Over the last three years, Brødrene A & O Johansen reported free cash flow worth 12% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Brødrene A & O Johansen's conversion of EBIT to free cash flow and level of total liabilities definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Brødrene A & O Johansen's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. Case in point: We've spotted 2 warning signs for Brødrene A & O Johansen you should be aware of.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.