Is AB (WSE:ABE) A Risky Investment?

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. Importantly, AB S.A. (WSE:ABE) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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 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. 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 AB

How Much Debt Does AB Carry?

As you can see below, AB had zł248.7m of debt at September 2020, down from zł290.4m a year prior. On the flip side, it has zł131.2m in cash leading to net debt of about zł117.5m.

How Strong Is AB's Balance Sheet?

We can see from the most recent balance sheet that AB had liabilities of zł1.58b falling due within a year, and liabilities of zł219.9m due beyond that. On the other hand, it had cash of zł131.2m and zł1.13b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by zł532.5m.

This is a mountain of leverage relative to its market capitalization of zł548.9m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While AB's low debt to EBITDA ratio of 1.00 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.4 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. If AB can keep growing EBIT at last year's rate of 19% over the last year, then it will find its debt load easier to manage. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine AB'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, AB's free cash flow amounted to 43% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Even if we have reservations about how easily AB is capable of staying on top of its total liabilities, its EBIT growth rate and net debt to EBITDA make us think feel relatively unconcerned. We think that AB's debt does make it a bit risky, after considering the aforementioned data points together. 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. For example, we've discovered 1 warning sign for AB that you should be aware of before investing here.

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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