Aker Solutions (OB:AKSO) Takes On Some Risk With Its Use Of Debt

David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the 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, Aker Solutions ASA (OB:AKSO) does carry debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Aker Solutions

How Much Debt Does Aker Solutions Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2019 Aker Solutions had øre3.58b of debt, an increase on øre2.82b, over one year. However, because it has a cash reserve of øre2.23b, its net debt is less, at about øre1.35b.

OB:AKSO Historical Debt, July 28th 2019
OB:AKSO Historical Debt, July 28th 2019

How Strong Is Aker Solutions’s Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Aker Solutions had liabilities of øre11.4b due within 12 months and liabilities of øre8.53b due beyond that. Offsetting this, it had øre2.23b in cash and øre8.42b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by øre9.27b.

Given this deficit is actually higher than the company’s market capitalization of øre7.94b, we think shareholders really should watch Aker Solutions’s debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While Aker Solutions’s low debt to EBITDA ratio of 0.83 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.9 last year does give us pause. So we’d recommend keeping a close eye on the impact financing costs are having on the business. It is well worth noting that Aker Solutions’s EBIT shot up like bamboo after rain, gaining 30% in the last twelve months. That’ll make it easier to manage its debt. 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 Aker Solutions’s ability to maintain a healthy balance sheet going forward. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Aker Solutions’s free cash flow amounted to 31% of its EBIT, less than we’d expect. That’s not great, when it comes to paying down debt.

Our View

Neither Aker Solutions’s ability to handle its total liabilities nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. Taking the abovementioned factors together we do think Aker Solutions’s debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. Given our hesitation about the stock, it would be good to know if Aker Solutions insiders have sold any shares recently. You click here to find out if insiders have sold recently.

Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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.