Here's Why Scandinavian Tobacco Group (CPH:STG) Can Manage Its Debt Responsibly

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 note that Scandinavian Tobacco Group A/S (CPH:STG) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. 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 Scandinavian Tobacco Group

What Is Scandinavian Tobacco Group's Net Debt?

As you can see below, Scandinavian Tobacco Group had kr.2.95b of debt, at September 2021, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has kr.123.0m in cash leading to net debt of about kr.2.83b.

A Look At Scandinavian Tobacco Group's Liabilities

Zooming in on the latest balance sheet data, we can see that Scandinavian Tobacco Group had liabilities of kr.1.64b due within 12 months and liabilities of kr.4.06b due beyond that. Offsetting this, it had kr.123.0m in cash and kr.1.08b in receivables that were due within 12 months. So it has liabilities totalling kr.4.49b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Scandinavian Tobacco Group has a market capitalization of kr.13.3b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Scandinavian Tobacco Group's net debt is only 1.4 times its EBITDA. And its EBIT easily covers its interest expense, being 14.5 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Another good sign is that Scandinavian Tobacco Group has been able to increase its EBIT by 22% in twelve months, making it easier to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Scandinavian Tobacco Group 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, 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. Over the last three years, Scandinavian Tobacco Group recorded free cash flow worth a fulsome 90% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

Happily, Scandinavian Tobacco Group's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Looking at the bigger picture, we think Scandinavian Tobacco Group's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for Scandinavian Tobacco Group you should be aware of.

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.