These 4 Measures Indicate That Strax (STO:STRAX) Is Using Debt In A Risky Way

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. Importantly, Strax AB (publ) (STO:STRAX) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 Strax

How Much Debt Does Strax Carry?

The image below, which you can click on for greater detail, shows that at March 2022 Strax had debt of €49.3m, up from €34.0m in one year. However, it does have €3.02m in cash offsetting this, leading to net debt of about €46.3m.

How Healthy Is Strax's Balance Sheet?

We can see from the most recent balance sheet that Strax had liabilities of €91.0m falling due within a year, and liabilities of €5.41m due beyond that. Offsetting this, it had €3.02m in cash and €24.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €68.8m.

This deficit casts a shadow over the €21.9m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Strax would likely require a major re-capitalisation if it had to pay its creditors today.

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

Weak interest cover of 0.37 times and a disturbingly high net debt to EBITDA ratio of 16.3 hit our confidence in Strax like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Worse, Strax's EBIT was down 70% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Strax can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Strax saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both Strax's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its interest cover fails to inspire much confidence. It looks to us like Strax carries a significant balance sheet burden. If you play with fire you risk getting burnt, so we'd probably give this stock a wide berth. 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 Strax is showing 2 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...

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.