Is Scandinavian Tobacco Group (CPH:STG) Using Too Much Debt?

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. Importantly, Scandinavian Tobacco Group A/S (CPH:STG) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out the opportunities and risks within the XX Tobacco industry.

What Is Scandinavian Tobacco Group's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2022 Scandinavian Tobacco Group had kr.3.49b of debt, an increase on kr.2.95b, over one year. And it doesn't have much cash, so its net debt is about the same.

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.1.66b due within 12 months and liabilities of kr.4.90b due beyond that. Offsetting this, it had kr.37.1m in cash and kr.1.20b in receivables that were due within 12 months. So it has liabilities totalling kr.5.33b 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.10.6b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Scandinavian Tobacco Group's net debt to EBITDA ratio of about 1.7 suggests only moderate use of debt. And its commanding EBIT of 17.3 times its interest expense, implies the debt load is as light as a peacock feather. The good news is that Scandinavian Tobacco Group has increased its EBIT by 3.7% over twelve months, which should ease any concerns about debt repayment. There's no doubt that we learn most about debt from the balance sheet. 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're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Scandinavian Tobacco Group recorded free cash flow worth 76% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Happily, Scandinavian Tobacco Group's impressive interest cover implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its level of total liabilities. Looking at all the aforementioned factors together, it strikes us that Scandinavian Tobacco Group can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Scandinavian Tobacco Group has 2 warning signs (and 1 which is potentially serious) we think 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.