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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.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Knowit AB (publ) (STO:KNOW) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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.
What Is Knowit’s Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Knowit had debt of kr289.3m, up from kr95.3m in one year. However, it also had kr97.2m in cash, and so its net debt is kr192.1m.
How Healthy Is Knowit’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Knowit had liabilities of kr810.9m due within 12 months and liabilities of kr233.8m due beyond that. Offsetting these obligations, it had cash of kr97.2m as well as receivables valued at kr849.6m due within 12 months. So it has liabilities totalling kr97.9m more than its cash and near-term receivables, combined.
Of course, Knowit has a market capitalization of kr3.60b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Since Knowit 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). 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).
Knowit has a low net debt to EBITDA ratio of only 0.53. And its EBIT easily covers its interest expense, being 127 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Fortunately, Knowit grew its EBIT by 6.7% in the last year, making that debt load look even more manageable. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Knowit’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Knowit produced sturdy free cash flow equating to 72% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
The good news is that Knowit’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that’s just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Zooming out, Knowit seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. Given Knowit has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.