Aktieselskabet Schouw (CPH:SCHO) Takes On Some Risk With Its Use Of Debt

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 note that Aktieselskabet Schouw & Co. (CPH:SCHO) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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, 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.

See our latest analysis for Aktieselskabet Schouw

What Is Aktieselskabet Schouw's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2022 Aktieselskabet Schouw had kr.4.89b of debt, an increase on kr.2.40b, over one year. However, it does have kr.567.0m in cash offsetting this, leading to net debt of about kr.4.32b.

How Healthy Is Aktieselskabet Schouw's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Aktieselskabet Schouw had liabilities of kr.9.29b due within 12 months and liabilities of kr.5.64b due beyond that. On the other hand, it had cash of kr.567.0m and kr.6.89b worth of receivables due within a year. So it has liabilities totalling kr.7.48b more than its cash and near-term receivables, combined.

Aktieselskabet Schouw has a market capitalization of kr.13.2b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

We'd say that Aktieselskabet Schouw's moderate net debt to EBITDA ratio ( being 2.2), indicates prudence when it comes to debt. And its strong interest cover of 25.5 times, makes us even more comfortable. Sadly, Aktieselskabet Schouw's EBIT actually dropped 5.4% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Aktieselskabet Schouw can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Aktieselskabet Schouw reported free cash flow worth 17% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Neither Aktieselskabet Schouw's ability to convert EBIT to free cash flow nor its EBIT growth rate gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Aktieselskabet Schouw is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for Aktieselskabet Schouw (1 is a bit concerning) you should be aware of.

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.