Is Arcoma (STO:ARCOMA) Using Too Much Debt?

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. We can see that Arcoma AB (STO:ARCOMA) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Arcoma

What Is Arcoma's Debt?

As you can see below, at the end of March 2023, Arcoma had kr19.2m of debt, up from kr18.4m a year ago. Click the image for more detail. On the flip side, it has kr4.75m in cash leading to net debt of about kr14.4m.

A Look At Arcoma's Liabilities

The latest balance sheet data shows that Arcoma had liabilities of kr47.0m due within a year, and liabilities of kr3.38m falling due after that. Offsetting this, it had kr4.75m in cash and kr23.7m in receivables that were due within 12 months. So it has liabilities totalling kr22.0m more than its cash and near-term receivables, combined.

Given Arcoma has a market capitalization of kr123.9m, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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 Arcoma's debt to EBITDA ratio (3.6) suggests that it uses some debt, its interest cover is very weak, at 2.2, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. One redeeming factor for Arcoma is that it turned last year's EBIT loss into a gain of kr2.2m, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Arcoma'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 company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Happily for any shareholders, Arcoma actually produced more free cash flow than EBIT over the last year. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

On our analysis Arcoma's conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. To be specific, it seems about as good at covering its interest expense with its EBIT as wet socks are at keeping your feet warm. We would also note that Medical Equipment industry companies like Arcoma commonly do use debt without problems. Considering this range of data points, we think Arcoma is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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, we've discovered 2 warning signs for Arcoma (1 doesn't sit too well with us!) that you should be aware of before investing here.

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.