Is W5 Solutions (STO:W5) A Risky Investment?

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.' 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. We can see that W5 Solutions AB (publ) (STO:W5) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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, 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.

Check out our latest analysis for W5 Solutions

What Is W5 Solutions's Net Debt?

As you can see below, at the end of December 2023, W5 Solutions had kr46.1m of debt, up from kr5.41m a year ago. Click the image for more detail. However, because it has a cash reserve of kr35.2m, its net debt is less, at about kr10.9m.

How Healthy Is W5 Solutions' Balance Sheet?

We can see from the most recent balance sheet that W5 Solutions had liabilities of kr163.1m falling due within a year, and liabilities of kr114.3m due beyond that. Offsetting this, it had kr35.2m in cash and kr110.2m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by kr132.0m.

Of course, W5 Solutions has a market capitalization of kr1.15b, 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. Carrying virtually no net debt, W5 Solutions has a very light debt load indeed.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While W5 Solutions's low debt to EBITDA ratio of 0.20 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.4 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Importantly, W5 Solutions's EBIT fell a jaw-dropping 73% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine W5 Solutions'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. Happily for any shareholders, W5 Solutions actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Based on what we've seen W5 Solutions is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to convert EBIT to free cash flow is pretty flash. Considering this range of data points, we think W5 Solutions is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. To that end, you should be aware of the 1 warning sign we've spotted with W5 Solutions .

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.