These 4 Measures Indicate That Investment AB Latour (STO:LATO B) Is Using Debt Safely

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. Importantly, Investment AB Latour (publ) (STO:LATO B) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Investment AB Latour

What Is Investment AB Latour's Debt?

As you can see below, at the end of December 2020, Investment AB Latour had kr8.77b of debt, up from kr8.38b a year ago. Click the image for more detail. On the flip side, it has kr4.03b in cash leading to net debt of about kr4.74b.

A Look At Investment AB Latour's Liabilities

The latest balance sheet data shows that Investment AB Latour had liabilities of kr4.84b due within a year, and liabilities of kr8.10b falling due after that. Offsetting these obligations, it had cash of kr4.03b as well as receivables valued at kr2.72b due within 12 months. So its liabilities total kr6.19b more than the combination of its cash and short-term receivables.

Of course, Investment AB Latour has a titanic market capitalization of kr159.4b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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).

Investment AB Latour's net debt to EBITDA ratio of about 2.0 suggests only moderate use of debt. And its commanding EBIT of 24.5 times its interest expense, implies the debt load is as light as a peacock feather. One way Investment AB Latour could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 16%, as it did over the last year. There's no doubt that we learn most about debt from the balance sheet. But it is Investment AB Latour's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Investment AB Latour generated free cash flow amounting to a very robust 81% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

The good news is that Investment AB Latour's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Zooming out, Investment AB Latour seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. 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 example, we've discovered 1 warning sign for Investment AB Latour that you should be aware of before investing here.

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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