Is UPM-Kymmene Oyj (HEL:UPM) Using Too Much Debt?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, UPM-Kymmene Oyj (HEL:UPM) does carry debt. But is this debt a concern to shareholders?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

Check out our latest analysis for UPM-Kymmene Oyj

What Is UPM-Kymmene Oyj's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 UPM-Kymmene Oyj had €4.34b of debt, an increase on €2.62b, over one year. However, because it has a cash reserve of €938.0m, its net debt is less, at about €3.40b.

How Healthy Is UPM-Kymmene Oyj's Balance Sheet?

We can see from the most recent balance sheet that UPM-Kymmene Oyj had liabilities of €2.82b falling due within a year, and liabilities of €5.29b due beyond that. On the other hand, it had cash of €938.0m and €2.59b worth of receivables due within a year. So it has liabilities totalling €4.57b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since UPM-Kymmene Oyj has a huge market capitalization of €18.2b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

UPM-Kymmene Oyj's net debt to EBITDA ratio of about 2.1 suggests only moderate use of debt. And its strong interest cover of 81.9 times, makes us even more comfortable. Also relevant is that UPM-Kymmene Oyj has grown its EBIT by a very respectable 24% in the last year, thus enhancing its ability to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if UPM-Kymmene Oyj 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, UPM-Kymmene Oyj saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

UPM-Kymmene Oyj's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its interest cover. When we consider all the factors mentioned above, we do feel a bit cautious about UPM-Kymmene Oyj's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. For instance, we've identified 2 warning signs for UPM-Kymmene Oyj (1 is a bit concerning) you should be aware of.

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.

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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.