Here's Why Cavotec (STO:CCC) Can Manage Its Debt Responsibly

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Cavotec SA (STO:CCC) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Cavotec

What Is Cavotec's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Cavotec had €14.0m of debt in March 2021, down from €26.7m, one year before. However, it does have €13.2m in cash offsetting this, leading to net debt of about €792.0k.

How Healthy Is Cavotec's Balance Sheet?

We can see from the most recent balance sheet that Cavotec had liabilities of €58.7m falling due within a year, and liabilities of €37.6m due beyond that. Offsetting this, it had €13.2m in cash and €44.6m in receivables that were due within 12 months. So it has liabilities totalling €38.3m more than its cash and near-term receivables, combined.

Since publicly traded Cavotec shares are worth a total of €242.9m, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Carrying virtually no net debt, Cavotec has a very light debt load indeed.

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

Given net debt is only 0.11 times EBITDA, it is initially surprising to see that Cavotec's EBIT has low interest coverage of 2.0 times. So while we're not necessarily alarmed we think that its debt is far from trivial. Importantly, Cavotec's EBIT fell a jaw-dropping 73% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 Cavotec'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.

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. During the last two years, Cavotec produced sturdy free cash flow equating to 67% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Cavotec's EBIT growth rate was a real negative on this analysis, as was its interest cover. But like a ballerina ending on a perfect pirouette, it has not trouble managing its debt, based on its EBITDA,. When we consider all the factors mentioned above, we do feel a bit cautious about Cavotec's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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 2 warning signs for Cavotec (1 doesn't sit too well with us) you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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. 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.
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