We Think AB Fagerhult (STO:FAG) Is Taking Some Risk With Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies AB Fagerhult (STO:FAG) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for AB Fagerhult

What Is AB Fagerhult's Debt?

The image below, which you can click on for greater detail, shows that AB Fagerhult had debt of kr3.96b at the end of September 2020, a reduction from kr4.27b over a year. However, because it has a cash reserve of kr1.49b, its net debt is less, at about kr2.46b.

How Healthy Is AB Fagerhult's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that AB Fagerhult had liabilities of kr1.78b due within 12 months and liabilities of kr5.65b due beyond that. Offsetting this, it had kr1.49b in cash and kr1.34b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by kr4.61b.

This deficit isn't so bad because AB Fagerhult is worth kr7.72b, and thus could probably raise enough capital to shore up 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 measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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 has a debt to EBITDA ratio of 3.3 and its EBIT covered its interest expense 4.2 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Even worse, AB Fagerhult saw its EBIT tank 48% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 Fagerhult'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, AB Fagerhult generated free cash flow amounting to a very robust 94% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

AB Fagerhult's EBIT growth rate and net debt to EBITDA definitely weigh on it, in our esteem. But the good news is it seems to be able to convert EBIT to free cash flow with ease. Taking the abovementioned factors together we do think AB Fagerhult's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. Take risks, for example - AB Fagerhult has 2 warning signs we think 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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