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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.’ 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, Catena AB (publ) (STO:CATE) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. If things get really bad, the lenders can take control of the business. 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.
What Is Catena’s Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Catena had debt of kr9.29b, up from kr8.82b in one year. And it doesn’t have much cash, so its net debt is about the same.
How Strong Is Catena’s Balance Sheet?
We can see from the most recent balance sheet that Catena had liabilities of kr4.59b falling due within a year, and liabilities of kr6.89b due beyond that. Offsetting these obligations, it had cash of kr135.8m as well as receivables valued at kr131.1m due within 12 months. So its liabilities total kr11.2b more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company’s market capitalization of kr11.0b, we think shareholders really should watch Catena’s debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. Since Catena does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, 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.
With a net debt to EBITDA ratio of 10.8, it’s fair to say Catena does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 3.82 times, suggesting it can responsibly service its obligations. However, one redeeming factor is that Catena grew its EBIT at 17% 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 ultimately the future profitability of the business will decide if Catena can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Catena recorded free cash flow of 48% of its EBIT, which is weaker than we’d expect. That’s not great, when it comes to paying down debt.
Mulling over Catena’s attempt at managing its debt, based on its EBITDA,, we’re certainly not enthusiastic. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Catena stock a bit risky. Some people like that sort of risk, but we’re mindful of the potential pitfalls, so we’d probably prefer it carry less debt. Given our hesitation about the stock, it would be good to know if Catena insiders have sold any shares recently. You click here to find out if insiders have sold recently.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.