Is Hufvudstaden (STO:HUFV A) 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 note that Hufvudstaden AB (publ) (STO:HUFV A) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Hufvudstaden

What Is Hufvudstaden's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2021 Hufvudstaden had debt of kr8.80b, up from kr8.20b in one year. However, because it has a cash reserve of kr925.2m, its net debt is less, at about kr7.87b.

How Strong Is Hufvudstaden's Balance Sheet?

The latest balance sheet data shows that Hufvudstaden had liabilities of kr4.07b due within a year, and liabilities of kr15.6b falling due after that. Offsetting this, it had kr925.2m in cash and kr75.1m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by kr18.7b.

This deficit is considerable relative to its market capitalization of kr26.9b, 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.

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).

While Hufvudstaden's debt to EBITDA ratio of 6.9 suggests a heavy debt load, its interest coverage of 9.4 implies it services that debt with ease. Our best guess is that the company does indeed have significant debt obligations. Unfortunately, Hufvudstaden's EBIT flopped 17% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Hufvudstaden 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Hufvudstaden recorded free cash flow worth a fulsome 88% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

Neither Hufvudstaden's ability handle its debt, based on its EBITDA, nor its EBIT growth rate 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. Taking the abovementioned factors together we do think Hufvudstaden's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 1 warning sign with Hufvudstaden , and understanding them should be part of your investment process.

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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