AB Volvo (STO:VOLV B) 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.' 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. Importantly, AB Volvo (publ) (STO:VOLV B) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

Check out our latest analysis for AB Volvo

What Is AB Volvo's Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2023 AB Volvo had kr232.1b of debt, an increase on kr207.4b, over one year. However, it does have kr84.9b in cash offsetting this, leading to net debt of about kr147.2b.

A Look At AB Volvo's Liabilities

According to the last reported balance sheet, AB Volvo had liabilities of kr284.4b due within 12 months, and liabilities of kr209.0b due beyond 12 months. On the other hand, it had cash of kr84.9b and kr60.3b worth of receivables due within a year. So its liabilities total kr348.2b more than the combination of its cash and short-term receivables.

AB Volvo has a very large market capitalization of kr622.3b, 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 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).

We'd say that AB Volvo's moderate net debt to EBITDA ratio ( being 1.7), indicates prudence when it comes to debt. And its commanding EBIT of 1k times its interest expense, implies the debt load is as light as a peacock feather. It is well worth noting that AB Volvo's EBIT shot up like bamboo after rain, gaining 71% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if AB Volvo can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, AB Volvo created free cash flow amounting to 10% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

AB Volvo's interest cover was a real positive on this analysis, as was its EBIT growth rate. On the other hand, its conversion of EBIT to free cash flow makes us a little less comfortable about its debt. Considering this range of data points, we think AB Volvo is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 2 warning signs we've spotted with AB Volvo (including 1 which is concerning) .

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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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.