We Think Svenska Cellulosa Aktiebolaget (STO:SCA B) Can Stay On Top Of Its 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.' 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 Svenska Cellulosa Aktiebolaget SCA (publ) (STO:SCA B) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Svenska Cellulosa Aktiebolaget

What Is Svenska Cellulosa Aktiebolaget's Debt?

As you can see below, at the end of June 2022, Svenska Cellulosa Aktiebolaget had kr10.9b of debt, up from kr9.95b a year ago. Click the image for more detail. However, it also had kr755.0m in cash, and so its net debt is kr10.2b.

How Strong Is Svenska Cellulosa Aktiebolaget's Balance Sheet?

The latest balance sheet data shows that Svenska Cellulosa Aktiebolaget had liabilities of kr7.98b due within a year, and liabilities of kr30.4b falling due after that. Offsetting this, it had kr755.0m in cash and kr4.35b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by kr33.2b.

This deficit isn't so bad because Svenska Cellulosa Aktiebolaget is worth kr98.4b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). 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).

Svenska Cellulosa Aktiebolaget's net debt is only 1.1 times its EBITDA. And its EBIT easily covers its interest expense, being 122 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Better yet, Svenska Cellulosa Aktiebolaget grew its EBIT by 261% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Svenska Cellulosa Aktiebolaget can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Svenska Cellulosa Aktiebolaget's free cash flow amounted to 31% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Svenska Cellulosa Aktiebolaget's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. All these things considered, it appears that Svenska Cellulosa Aktiebolaget can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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 Svenska Cellulosa Aktiebolaget is showing 2 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

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.