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.' 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. Importantly, Solar A/S (CPH:SOLAR B) does carry debt. But the real question is whether this debt is making the company risky.
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is Solar's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Solar had kr.317.0m of debt in December 2020, down from kr.717.0m, one year before. But it also has kr.404.0m in cash to offset that, meaning it has kr.87.0m net cash.
How Strong Is Solar's Balance Sheet?
According to the last reported balance sheet, Solar had liabilities of kr.2.41b due within 12 months, and liabilities of kr.498.0m due beyond 12 months. Offsetting these obligations, it had cash of kr.404.0m as well as receivables valued at kr.1.29b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by kr.1.22b.
Solar has a market capitalization of kr.3.30b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. Despite its noteworthy liabilities, Solar boasts net cash, so it's fair to say it does not have a heavy debt load!
In addition to that, we're happy to report that Solar has boosted its EBIT by 34%, thus reducing the spectre of future debt repayments. 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 Solar's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Solar has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Happily for any shareholders, Solar actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
Although Solar's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of kr.87.0m. And it impressed us with free cash flow of kr.730m, being 105% of its EBIT. So we don't think Solar's use of debt is risky. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Solar (of which 1 is a bit concerning!) 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. 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.
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