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. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Stockmann Oyj Abp (HEL:STCBV) does carry debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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 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.
What Is Stockmann Oyj Abp’s Net Debt?
The image below, which you can click on for greater detail, shows that Stockmann Oyj Abp had debt of €464.8m at the end of September 2019, a reduction from €647.9m over a year. On the flip side, it has €12.2m in cash leading to net debt of about €452.6m.
A Look At Stockmann Oyj Abp’s Liabilities
Zooming in on the latest balance sheet data, we can see that Stockmann Oyj Abp had liabilities of €356.8m due within 12 months and liabilities of €993.2m due beyond that. On the other hand, it had cash of €12.2m and €48.1m worth of receivables due within a year. So it has liabilities totalling €1.29b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the €166.9m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet.” So we definitely think shareholders need to watch this one closely. After all, Stockmann Oyj Abp would likely require a major re-capitalisation if it had to pay its creditors today.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Weak interest cover of 0.40 times and a disturbingly high net debt to EBITDA ratio of 6.1 hit our confidence in Stockmann Oyj Abp like a one-two punch to the gut. The debt burden here is substantial. The silver lining is that Stockmann Oyj Abp grew its EBIT by 215% last year, which nourishing like the idealism of youth. If it can keep walking that path it will be in a position to shed its debt with relative ease. 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 Stockmann Oyj Abp’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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Stockmann Oyj Abp actually produced more free cash flow than EBIT over the last three years. There’s nothing better than incoming cash when it comes to staying in your lenders’ good graces.
On the face of it, Stockmann Oyj Abp’s interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Stockmann Oyj Abp’s debt is making it a bit risky. That’s not necessarily a bad thing, but we’d generally feel more comfortable with less leverage. Even though Stockmann Oyj Abp lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check outhow earnings have been trending over the last few years.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.