Is SKAKO (CPH:SKAKO) 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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that SKAKO A/S (CPH:SKAKO) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for SKAKO

What Is SKAKO's Net Debt?

The image below, which you can click on for greater detail, shows that SKAKO had debt of kr.41.6m at the end of June 2024, a reduction from kr.93.6m over a year. However, it does have kr.22.3m in cash offsetting this, leading to net debt of about kr.19.3m.

How Healthy Is SKAKO's Balance Sheet?

According to the last reported balance sheet, SKAKO had liabilities of kr.136.9m due within 12 months, and liabilities of kr.18.4m due beyond 12 months. Offsetting these obligations, it had cash of kr.22.3m as well as receivables valued at kr.122.2m due within 12 months. So it has liabilities totalling kr.10.7m more than its cash and near-term receivables, combined.

Of course, SKAKO has a market capitalization of kr.241.6m, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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

SKAKO has a low debt to EBITDA ratio of only 0.80. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. Also positive, SKAKO grew its EBIT by 25% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is SKAKO's earnings that will influence how the balance sheet holds up in the future. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, SKAKO recorded free cash flow of 26% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

The good news is that SKAKO's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. When we consider the range of factors above, it looks like SKAKO is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example SKAKO has 3 warning signs (and 2 which are concerning) we think you should know about.

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.

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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.