Is Aktieselskabet Schouw (CPH:SCHO) 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.' 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. We can see that Aktieselskabet Schouw & Co. (CPH:SCHO) does use debt in its business. But should shareholders be worried about its use of debt?

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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

See our latest analysis for Aktieselskabet Schouw

What Is Aktieselskabet Schouw's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 Aktieselskabet Schouw had kr.4.34b of debt, an increase on kr.2.42b, over one year. However, it does have kr.496.0m in cash offsetting this, leading to net debt of about kr.3.84b.

How Healthy Is Aktieselskabet Schouw's Balance Sheet?

We can see from the most recent balance sheet that Aktieselskabet Schouw had liabilities of kr.8.55b falling due within a year, and liabilities of kr.5.01b due beyond that. Offsetting these obligations, it had cash of kr.496.0m as well as receivables valued at kr.5.82b due within 12 months. So it has liabilities totalling kr.7.24b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of kr.10.6b, so it does suggest shareholders should keep an eye on Aktieselskabet Schouw's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Aktieselskabet Schouw's net debt to EBITDA ratio of about 2.0 suggests only moderate use of debt. And its commanding EBIT of 87.1 times its interest expense, implies the debt load is as light as a peacock feather. The bad news is that Aktieselskabet Schouw saw its EBIT decline by 14% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. 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 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Aktieselskabet Schouw's free cash flow amounted to 40% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Neither Aktieselskabet Schouw's ability to grow its EBIT nor its level of total liabilities gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. 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. To that end, you should be aware of the 1 warning sign we've spotted with Aktieselskabet Schouw .

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.