Is Hufvudstaden (STO:HUFV A) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Hufvudstaden AB (publ) (STO:HUFV A) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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.

See our latest analysis for Hufvudstaden

What Is Hufvudstaden's Debt?

As you can see below, at the end of September 2020, Hufvudstaden had kr8.25b of debt, up from kr7.85b a year ago. Click the image for more detail. However, because it has a cash reserve of kr366.2m, its net debt is less, at about kr7.88b.

How Healthy Is Hufvudstaden's Balance Sheet?

The latest balance sheet data shows that Hufvudstaden had liabilities of kr2.88b due within a year, and liabilities of kr15.7b falling due after that. Offsetting this, it had kr366.2m in cash and kr67.6m in receivables that were due within 12 months. So it has liabilities totalling kr18.1b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of kr26.3b, so it does suggest shareholders should keep an eye on Hufvudstaden's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Hufvudstaden's debt to EBITDA ratio of 6.1 suggests a heavy debt load, its interest coverage of 9.7 implies it services that debt with ease. Our best guess is that the company does indeed have significant debt obligations. Sadly, Hufvudstaden's EBIT actually dropped 7.4% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Hufvudstaden'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Hufvudstaden recorded free cash flow worth a fulsome 86% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

Hufvudstaden's net debt to EBITDA and EBIT growth rate definitely weigh on it, in our esteem. But the good news is it seems to be able to convert EBIT to free cash flow with ease. Looking at all the angles mentioned above, it does seem to us that Hufvudstaden is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Hufvudstaden that you should be aware of.

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. 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.
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