AB Fagerhult (publ.) (STO:FAG) Seems To Use Debt Quite Sensibly

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. As with many other companies AB Fagerhult (publ.) (STO:FAG) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for AB Fagerhult (publ.)

What Is AB Fagerhult (publ.)'s Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2022 AB Fagerhult (publ.) had kr4.23b of debt, an increase on kr3.72b, over one year. However, it also had kr1.06b in cash, and so its net debt is kr3.17b.

A Look At AB Fagerhult (publ.)'s Liabilities

Zooming in on the latest balance sheet data, we can see that AB Fagerhult (publ.) had liabilities of kr2.02b due within 12 months and liabilities of kr4.47b due beyond that. On the other hand, it had cash of kr1.06b and kr1.61b worth of receivables due within a year. So it has liabilities totalling kr3.81b more than its cash and near-term receivables, combined.

AB Fagerhult (publ.) has a market capitalization of kr7.58b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

AB Fagerhult (publ.) has a debt to EBITDA ratio of 3.2, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 14.4 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. AB Fagerhult (publ.) grew its EBIT by 9.9% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since AB Fagerhult (publ.) will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, AB Fagerhult (publ.) actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

AB Fagerhult (publ.)'s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But truth be told we feel its net debt to EBITDA does undermine this impression a bit. All these things considered, it appears that AB Fagerhult (publ.) can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example AB Fagerhult (publ.) has 3 warning signs (and 1 which is a bit unpleasant) we think 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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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.