Is Scandinavian Tobacco Group (CPH:STG) 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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Scandinavian Tobacco Group A/S (CPH:STG) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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.

View our latest analysis for Scandinavian Tobacco Group

What Is Scandinavian Tobacco Group's Debt?

As you can see below, Scandinavian Tobacco Group had kr.2.92b of debt, at December 2021, which is about the same as the year before. You can click the chart for greater detail. However, it also had kr.173.6m in cash, and so its net debt is kr.2.74b.

How Healthy Is Scandinavian Tobacco Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Scandinavian Tobacco Group had liabilities of kr.1.47b due within 12 months and liabilities of kr.4.15b due beyond that. Offsetting this, it had kr.173.6m in cash and kr.1.02b in receivables that were due within 12 months. So it has liabilities totalling kr.4.42b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Scandinavian Tobacco Group is worth kr.13.6b, and thus could probably raise enough capital to shore up 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.

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.

Scandinavian Tobacco Group has a low net debt to EBITDA ratio of only 1.3. And its EBIT covers its interest expense a whopping 23.9 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also positive, Scandinavian Tobacco Group grew its EBIT by 30% in the last year, and that should make it easier to pay down debt, going forward. 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 Scandinavian Tobacco Group 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. 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

Scandinavian Tobacco Group's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Zooming out, Scandinavian Tobacco Group seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return 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. Be aware that Scandinavian Tobacco Group 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.