Is Smurfit Kappa Group (ISE:SK3) 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 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. We note that Smurfit Kappa Group Plc (ISE:SK3) 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. 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 Debt?

As you can see below, Smurfit Kappa Group had €2.93b of debt at December 2020, down from €3.31b a year prior. However, it does have €891.0m in cash offsetting this, leading to net debt of about €2.04b.

How Healthy Is Smurfit Kappa Group's Balance Sheet?

The latest balance sheet data shows that Smurfit Kappa Group had liabilities of €2.23b due within a year, and liabilities of €4.28b falling due after that. Offsetting this, it had €891.0m in cash and €1.46b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €4.16b.

While this might seem like a lot, it is not so bad since Smurfit Kappa Group has a huge market capitalization of €11.7b, 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.

Smurfit Kappa Group has net debt of just 1.5 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 7.3 times, which is more than adequate. But the bad news is that Smurfit Kappa Group has seen its EBIT plunge 13% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. When analysing debt levels, the balance sheet is the obvious place to start. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Smurfit Kappa Group produced sturdy free cash flow equating to 57% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Smurfit Kappa Group's EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability to to convert EBIT to free cash flow isn't too shabby at all. We think that Smurfit Kappa 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. When analysing debt levels, the balance sheet is the obvious place to start. 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 .

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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