Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We can see that Alfa Laval AB (publ) (STO:ALFA) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Alfa Laval Carry?
As you can see below, Alfa Laval had kr11.7b of debt at September 2020, down from kr12.3b a year prior. However, it also had kr6.80b in cash, and so its net debt is kr4.87b.
How Healthy Is Alfa Laval's Balance Sheet?
The latest balance sheet data shows that Alfa Laval had liabilities of kr18.6b due within a year, and liabilities of kr16.5b falling due after that. Offsetting these obligations, it had cash of kr6.80b as well as receivables valued at kr11.1b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by kr17.2b.
Of course, Alfa Laval has a titanic market capitalization of kr96.9b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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.
Alfa Laval has a low net debt to EBITDA ratio of only 0.59. And its EBIT covers its interest expense a whopping 28.8 times over. So we're pretty relaxed about its super-conservative use of debt. Alfa Laval's EBIT was pretty flat over the last year, but that shouldn't be an issue given the it doesn't have a lot of debt. 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 Alfa Laval'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Alfa Laval recorded free cash flow worth 69% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Happily, Alfa Laval's impressive interest cover implies it has the upper hand on its debt. And that's just the beginning of the good news since its net debt to EBITDA is also very heartening. When we consider the range of factors above, it looks like Alfa Laval is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that Alfa Laval is showing 1 warning sign in our investment analysis , you should know about...
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.
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