Is Scandinavian Tobacco Group (CPH:STG) A Risky Investment?

Warren Buffett famously said, '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 the real question is whether this debt is making the company risky.

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Scandinavian Tobacco Group

What Is Scandinavian Tobacco Group's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Scandinavian Tobacco Group had kr.4.89b of debt, an increase on kr.4.64b, over one year. And it doesn't have much cash, so its net debt is about the same.

How Strong Is Scandinavian Tobacco Group's Balance Sheet?

According to the last reported balance sheet, Scandinavian Tobacco Group had liabilities of kr.1.48b due within 12 months, and liabilities of kr.6.07b due beyond 12 months. On the other hand, it had cash of kr.89.6m and kr.1.29b worth of receivables due within a year. So it has liabilities totalling kr.6.17b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of kr.8.73b, so it does suggest shareholders should keep an eye on Scandinavian Tobacco Group'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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Scandinavian Tobacco Group has a debt to EBITDA ratio of 2.5, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 12.1 is very high, suggesting that the interest expense on the debt is currently quite low. The bad news is that Scandinavian Tobacco Group saw its EBIT decline by 12% over the last year. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Scandinavian Tobacco Group's ability to maintain a healthy balance sheet going forward. 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. During the last three years, Scandinavian Tobacco Group produced sturdy free cash flow equating to 56% 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.

Our View

Scandinavian Tobacco Group's EBIT growth rate and level of total liabilities definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. We think that Scandinavian Tobacco Group's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 2 warning signs we've spotted with Scandinavian Tobacco Group .

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.