Acroud (STO:ACROUD) Has A Somewhat Strained Balance Sheet

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Acroud AB (publ) (STO:ACROUD) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Our analysis indicates that ACROUD is potentially undervalued!

What Is Acroud's Debt?

You can click the graphic below for the historical numbers, but it shows that Acroud had €17.8m of debt in June 2022, down from €20.5m, one year before. However, it also had €1.24m in cash, and so its net debt is €16.6m.

How Strong Is Acroud's Balance Sheet?

According to the last reported balance sheet, Acroud had liabilities of €27.2m due within 12 months, and liabilities of €5.15m due beyond 12 months. Offsetting these obligations, it had cash of €1.24m as well as receivables valued at €4.08m due within 12 months. So it has liabilities totalling €27.1m more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's €21.4m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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.

While Acroud's debt to EBITDA ratio (2.8) suggests that it uses some debt, its interest cover is very weak, at 2.1, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Fortunately, Acroud grew its EBIT by 7.0% in the last year, slowly shrinking its debt relative to earnings. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Acroud's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Acroud's free cash flow amounted to 49% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

To be frank both Acroud's level of total liabilities and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that Acroud's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. For example Acroud has 3 warning signs (and 1 which is a bit concerning) we think you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.