AB Volvo (STO:VOLV B) Takes On Some Risk With Its Use Of Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 AB Volvo (publ) (STO:VOLV B) makes use of debt. But should shareholders be worried about its use of debt?

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, 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for AB Volvo

What Is AB Volvo's Net Debt?

As you can see below, at the end of September 2022, AB Volvo had kr205.1b of debt, up from kr135.5b a year ago. Click the image for more detail. However, because it has a cash reserve of kr72.0b, its net debt is less, at about kr133.1b.

How Strong Is AB Volvo's Balance Sheet?

According to the last reported balance sheet, AB Volvo had liabilities of kr247.5b due within 12 months, and liabilities of kr204.5b due beyond 12 months. Offsetting these obligations, it had cash of kr72.0b as well as receivables valued at kr74.8b due within 12 months. So it has liabilities totalling kr305.2b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its very significant market capitalization of kr389.8b, so it does suggest shareholders should keep an eye on AB Volvo's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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.

AB Volvo's net debt is 2.7 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 114 is very high, suggesting that the interest expense on the debt is currently quite low. Unfortunately, AB Volvo saw its EBIT slide 5.3% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. 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 AB Volvo'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 it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, AB Volvo recorded free cash flow of 36% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Neither AB Volvo's ability to handle its total liabilities nor its EBIT growth rate gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that AB Volvo is taking some risks with its use of debt. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - AB Volvo has 2 warning signs we think you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.