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. 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 Kakel Max AB (publ) (STO:KAKEL) makes use of debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does Kakel Max Carry?
The image below, which you can click on for greater detail, shows that Kakel Max had debt of kr7.95m at the end of June 2019, a reduction from kr10.5m over a year. On the flip side, it has kr4.19m in cash leading to net debt of about kr3.76m.
How Healthy Is Kakel Max’s Balance Sheet?
We can see from the most recent balance sheet that Kakel Max had liabilities of kr29.9m falling due within a year, and liabilities of kr26.6m due beyond that. Offsetting these obligations, it had cash of kr4.19m as well as receivables valued at kr23.2m due within 12 months. So its liabilities total kr29.1m more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of kr32.2m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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.
With net debt sitting at just 0.57 times EBITDA, Kakel Max is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 8.2 times the interest expense over the last year. The good news is that Kakel Max has increased its EBIT by 9.8% over twelve months, which should ease any concerns about debt repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Kakel Max’s earnings that will influence how the balance sheet holds up in the future. So if you’re keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Kakel Max saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Mulling over Kakel Max’s attempt at converting EBIT to free cash flow, we’re certainly not enthusiastic. But at least it’s pretty decent at managing its debt, based on its EBITDA,; that’s encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Kakel Max stock a bit risky. Some people like that sort of risk, but we’re mindful of the potential pitfalls, so we’d probably prefer it carry less debt. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you’ve also come to that realization, you’re in luck, because today you can view this interactive graph of Kakel Max’s earnings per share history for free.
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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If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.