Warren Buffett famously said, “Volatility is far from synonymous with risk.” So it seems that the smart money knows that debt — which usually plays a role in bankruptcies — is a very important factor when considering risk of a company. We can see that AddLife AB (Ed.) (STO:ALIF B) uses debt in its business. But is that debt a problem for shareholders?
What is the risk of debt?
Debt typically only becomes a real problem when a company cannot easily repay it, whether by raising capital or using its own cash flow. Ultimately, if the company fails to meet its legal obligations to pay down debt, shareholders could get away with nothing. While not all that common, we often see leveraged companies permanently diluting shareholders as lenders force them to raise capital at a distressed price. Of course, the benefit of leverage is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high returns. The first step in looking at a company’s debt is to look at its cash and debt together.
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What is AddLife’s net debt?
As you can see below, AddLife had debts of kr5.35 billion at the end of June 2022, up from kr3.78 billion a year ago. Click on the picture for more details. However, it has cash on hand of 351.0m kr, resulting in net debt of approximately 4.99bn kr.
How healthy is AddLife’s balance sheet?
The most recent balance sheet shows that AddLife had liabilities of kr 6.63 billion maturing within one year and liabilities of kr 1.52 billion maturing beyond that. This was offset by kr 351.0 million in cash and kr 1.51 billion in receivables due within 12 months. So his liabilities are DKK 6.30 billion more than the combination of cash and short-term receivables.
While this may seem like a lot, it’s not too bad as AddLife has a market cap of kr14.3bn and could therefore likely strengthen its balance sheet by raising capital if the need arose. But it’s clear that we should definitely look closely at whether it can manage its debt without dilution.
We measure a company’s debt burden relative to its profitability by dividing its net debt by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how well its earnings before interest and taxes (EBIT) are covering its interest costs (interest coverage) . The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio).
AddLife has a debt-to-EBITDA ratio of 3.4, which indicates it has significant debt but is still pretty reasonable for most types of businesses. However, the interest coverage is very high at 12.7, suggesting that the interest expense on the debt is quite low at the moment. AddLife’s EBIT, in particular, was pretty flat last year. Ideally, it can reduce its debt burden by boosting earnings growth. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, the company’s future profitability will determine whether AddLife can strengthen its balance sheet over time. So if you want to see what the experts think, you might be interested in this free report on analyst earnings forecasts.
After all, a business needs free cash flow to pay off debt; Accounting profits just don’t cut it. So we always check how much of that EBIT translates into free cash flow. Fortunately for all shareholders, AddLife has actually generated more free cash flow than EBIT over the past three years. This kind of strong cash generation warms our hearts like a puppy in a bumblebee costume.
The good news is that AddLife’s proven ability to cover its interest expense with its EBIT pleases us like a fluffy puppy pleases a toddler. But, to put it more grimly, we’re a little concerned about its net debt to EBITDA ratio. When we consider all of the above factors together, it strikes us that AddLife is pretty comfortable managing its debt. While this leverage can improve return on equity, it obviously comes with more risk, so it’s worth keeping an eye on. Undoubtedly, we learn most about debt from the balance sheet. But ultimately, any business can have off-balance-sheet risks. You should find out more about this 3 warning signs we discovered with AddLife (including 1 that shouldn’t be ignored) .
If, after all that, you’re more interested in a fast-growing company with a rock-solid balance sheet, check out our list of net cash growth stocks right away.
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