We Think Midway Holding (STO:MIDW B) Is Taking Some Risk With Its Debt

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 Midway Holding AB (publ) (STO:MIDW B) makes use of debt. But the real question is whether this debt is making the company risky.

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 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 Midway Holding

What Is Midway Holding's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2022 Midway Holding had debt of kr315.0m, up from kr180.0m in one year. On the flip side, it has kr130.0m in cash leading to net debt of about kr185.0m.

How Strong Is Midway Holding's Balance Sheet?

The latest balance sheet data shows that Midway Holding had liabilities of kr317.2m due within a year, and liabilities of kr674.0m falling due after that. On the other hand, it had cash of kr130.0m and kr160.1m worth of receivables due within a year. So its liabilities total kr701.1m more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of kr677.6m, we think shareholders really should watch Midway Holding's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Midway Holding's net debt is only 1.3 times its EBITDA. And its EBIT covers its interest expense a whopping 39.0 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Even more impressive was the fact that Midway Holding grew its EBIT by 178% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. 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 Midway Holding'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Midway Holding saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

While Midway Holding's conversion of EBIT to free cash flow has us nervous. To wit both its interest cover and EBIT growth rate were encouraging signs. Looking at all the angles mentioned above, it does seem to us that Midway Holding is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Midway Holding is showing 3 warning signs in our investment analysis , and 1 of those can't be ignored...

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.