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. As with many other companies Rockwool A/S (CPH:ROCK B) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. 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, 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Rockwool's Debt?
The image below, which you can click on for greater detail, shows that Rockwool had debt of €27.0m at the end of December 2021, a reduction from €101.0m over a year. But it also has €166.0m in cash to offset that, meaning it has €139.0m net cash.
How Healthy Is Rockwool's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Rockwool had liabilities of €523.0m due within 12 months and liabilities of €163.0m due beyond that. On the other hand, it had cash of €166.0m and €444.0m worth of receivables due within a year. So it has liabilities totalling €76.0m more than its cash and near-term receivables, combined.
This state of affairs indicates that Rockwool's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the €5.77b company is short on cash, but still worth keeping an eye on the balance sheet. Despite its noteworthy liabilities, Rockwool boasts net cash, so it's fair to say it does not have a heavy debt load!
Also good is that Rockwool grew its EBIT at 18% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Rockwool'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Rockwool may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, Rockwool created free cash flow amounting to 18% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Rockwool has €139.0m in net cash. And we liked the look of last year's 18% year-on-year EBIT growth. So we are not troubled with Rockwool's debt use. 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 Rockwool .
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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.