We Think AB Volvo (STO:VOLV B) Can Stay On Top Of Its 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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. 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?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View 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 March 2024 AB Volvo had kr245.7b of debt, an increase on kr211.1b, over one year. On the flip side, it has kr91.4b in cash leading to net debt of about kr154.2b.

How Strong Is AB Volvo's Balance Sheet?

The latest balance sheet data shows that AB Volvo had liabilities of kr334.3b due within a year, and liabilities of kr221.7b falling due after that. Offsetting these obligations, it had cash of kr91.4b as well as receivables valued at kr68.9b due within 12 months. So its liabilities total kr395.7b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its very significant market capitalization of kr548.3b, 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.

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.

We'd say that AB Volvo's moderate net debt to EBITDA ratio ( being 1.8), indicates prudence when it comes to debt. And its strong interest cover of 1k times, makes us even more comfortable. Importantly, AB Volvo grew its EBIT by 45% over the last twelve months, and that growth will make it easier to handle 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, AB Volvo created free cash flow amounting to 12% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Both AB Volvo's ability to to cover its interest expense with its EBIT and its EBIT growth rate gave us comfort that it can handle its debt. Having said that, its conversion of EBIT to free cash flow somewhat sensitizes us to potential future risks to the balance sheet. When we consider all the factors mentioned above, we do feel a bit cautious about AB Volvo's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. Be aware that AB Volvo is showing 2 warning signs in our investment analysis , and 1 of those is potentially serious...

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com