These 4 Measures Indicate That AAK AB (publ.) (STO:AAK) Is Using Debt Reasonably Well

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 AAK AB (publ.) (STO:AAK) does use debt in its business. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for AAK AB (publ.)

What Is AAK AB (publ.)'s Debt?

The image below, which you can click on for greater detail, shows that AAK AB (publ.) had debt of kr4.13b at the end of June 2021, a reduction from kr4.64b over a year. However, it also had kr1.14b in cash, and so its net debt is kr2.99b.

A Look At AAK AB (publ.)'s Liabilities

The latest balance sheet data shows that AAK AB (publ.) had liabilities of kr9.75b due within a year, and liabilities of kr3.77b falling due after that. On the other hand, it had cash of kr1.14b and kr6.30b worth of receivables due within a year. So its liabilities total kr6.08b more than the combination of its cash and short-term receivables.

Of course, AAK AB (publ.) has a market capitalization of kr51.6b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

AAK AB (publ.)'s net debt is only 1.1 times its EBITDA. And its EBIT easily covers its interest expense, being 22.2 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, AAK AB (publ.) saw its EBIT drop by 2.9% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine AAK AB (publ.)'s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, AAK AB (publ.)'s free cash flow amounted to 44% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

On our analysis AAK AB (publ.)'s interest cover should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit to grow its EBIT. Considering this range of data points, we think AAK AB (publ.) 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. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for AAK AB (publ.) that you should be aware of before investing here.

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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