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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Ambea AB (publ) (STO:AMBEA) does carry debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Ambea's Debt?
You can click the graphic below for the historical numbers, but it shows that Ambea had kr2.92b of debt in September 2020, down from kr3.68b, one year before. And it doesn't have much cash, so its net debt is about the same.
How Strong Is Ambea's Balance Sheet?
We can see from the most recent balance sheet that Ambea had liabilities of kr3.84b falling due within a year, and liabilities of kr6.61b due beyond that. Offsetting this, it had kr52.0m in cash and kr1.16b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by kr9.24b.
This deficit casts a shadow over the kr5.24b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Ambea would likely require a major re-capitalisation if it had to pay its creditors today.
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.
Ambea's debt is 3.2 times its EBITDA, and its EBIT cover its interest expense 3.3 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. However, one redeeming factor is that Ambea grew its EBIT at 11% over the last 12 months, boosting its ability to handle its debt. 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 Ambea'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. Over the last three years, Ambea actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Neither Ambea's ability to handle its total liabilities nor its interest cover gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. We should also note that Healthcare industry companies like Ambea commonly do use debt without problems. When we consider all the factors discussed, it seems to us that Ambea is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. Be aware that Ambea is showing 2 warning signs in our investment analysis , you should know about...
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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