Is Smurfit Kappa Group (ISE:SK3) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Smurfit Kappa Group Plc (ISE:SK3) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Smurfit Kappa Group

What Is Smurfit Kappa Group's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Smurfit Kappa Group had €2.84b of debt in December 2020, down from €3.31b, one year before. However, because it has a cash reserve of €891.0m, its net debt is less, at about €1.95b.

A Look At Smurfit Kappa Group's Liabilities

We can see from the most recent balance sheet that Smurfit Kappa Group had liabilities of €2.23b falling due within a year, and liabilities of €4.28b due beyond that. Offsetting this, it had €891.0m in cash and €1.54b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €4.08b.

This deficit isn't so bad because Smurfit Kappa Group is worth a massive €10.6b, 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.

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.

While Smurfit Kappa Group's low debt to EBITDA ratio of 1.3 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.0 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Unfortunately, Smurfit Kappa Group's EBIT flopped 14% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Smurfit Kappa Group can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Smurfit Kappa Group recorded free cash flow worth 58% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Smurfit Kappa Group's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example, its conversion of EBIT to free cash flow is relatively strong. Looking at all the angles mentioned above, it does seem to us that Smurfit Kappa Group is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. To that end, you should be aware of the 3 warning signs we've spotted with Smurfit Kappa Group .

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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