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.' 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 can see that Bang & Olufsen a/s (CPH:BO) does use debt in its business. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is Bang & Olufsen's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Bang & Olufsen had kr.209.0m of debt in February 2022, down from kr.257.0m, one year before. But it also has kr.651.0m in cash to offset that, meaning it has kr.442.0m net cash.
How Healthy Is Bang & Olufsen's Balance Sheet?
According to the last reported balance sheet, Bang & Olufsen had liabilities of kr.1.18b due within 12 months, and liabilities of kr.239.0m due beyond 12 months. Offsetting these obligations, it had cash of kr.651.0m as well as receivables valued at kr.580.0m due within 12 months. So it has liabilities totalling kr.190.0m more than its cash and near-term receivables, combined.
Given Bang & Olufsen has a market capitalization of kr.1.70b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Bang & Olufsen also has more cash than debt, so we're pretty confident it can manage its debt safely.
We also note that Bang & Olufsen improved its EBIT from a last year's loss to a positive kr.63m. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Bang & Olufsen can strengthen its balance sheet over time. 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. Bang & Olufsen 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. During the last year, Bang & Olufsen produced sturdy free cash flow equating to 79% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Although Bang & Olufsen'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.442.0m. The cherry on top was that in converted 79% of that EBIT to free cash flow, bringing in kr.50m. So we don't have any problem with Bang & Olufsen's use of debt. 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. Be aware that Bang & Olufsen is showing 1 warning sign in our investment analysis , you should know about...
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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.