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. Importantly, StrongPoint ASA (OB:STRO) does carry debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does StrongPoint Carry?
You can click the graphic below for the historical numbers, but it shows that StrongPoint had kr35.0m of debt in June 2022, down from kr43.4m, one year before. However, it does have kr50.5m in cash offsetting this, leading to net cash of kr15.5m.
How Healthy Is StrongPoint's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that StrongPoint had liabilities of kr352.7m due within 12 months and liabilities of kr63.7m due beyond that. Offsetting this, it had kr50.5m in cash and kr281.6m in receivables that were due within 12 months. So it has liabilities totalling kr84.3m more than its cash and near-term receivables, combined.
Since publicly traded StrongPoint shares are worth a total of kr731.5m, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, StrongPoint boasts net cash, so it's fair to say it does not have a heavy debt load!
It is just as well that StrongPoint's load is not too heavy, because its EBIT was down 38% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if StrongPoint 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, a company can only pay off debt with cold hard cash, not accounting profits. StrongPoint may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Happily for any shareholders, StrongPoint actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Although StrongPoint's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of kr15.5m. And it impressed us with free cash flow of kr150m, being 399% of its EBIT. So we don't have any problem with StrongPoint's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for StrongPoint that you should be aware of.
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.
Valuation is complex, but we're helping make it simple.
Find out whether StrongPoint is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.View the Free Analysis
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.