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.’ 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. We can see that Akastor ASA (OB:AKA) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Akastor Carry?
The chart below, which you can click on for greater detail, shows that Akastor had kr1.71b in debt in June 2019; about the same as the year before. On the flip side, it has kr281.0m in cash leading to net debt of about kr1.43b.
How Strong Is Akastor’s Balance Sheet?
We can see from the most recent balance sheet that Akastor had liabilities of kr3.38b falling due within a year, and liabilities of kr3.01b due beyond that. Offsetting these obligations, it had cash of kr281.0m as well as receivables valued at kr3.93b due within 12 months. So its liabilities total kr2.18b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of kr2.94b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). 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).
As it happens Akastor has a fairly concerning net debt to EBITDA ratio of 5.1 but very strong interest coverage of 1k. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Notably, Akastor made a loss at the EBIT level, last year, but improved that to positive EBIT of kr103m in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Akastor’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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Akastor burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, Akastor’s net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least it’s pretty decent at covering its interest expense with its EBIT; that’s encouraging. Overall, we think it’s fair to say that Akastor has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. Even though Akastor 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.
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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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.