These 4 measures indicate that Akzo Nobel (AMS:AKZA) is using debt extensively

Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. Above all, Akzo Nobel SA (AMS:AKZA) is in debt. But the real question is whether this debt makes the business risky.

What risk does debt carry?

Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. In the worst case, 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 at a low price, thereby permanently diluting shareholders. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. When we look at debt levels, we first consider cash and debt levels, together.

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What is Akzo Nobel’s debt?

You can click on the graph below for historical figures, but it shows that in September 2022, Akzo Nobel had 5.32 billion euros in debt, an increase from 3.08 billion euros, on a year. On the other hand, it has €1.37 billion in cash, which results in a net debt of around €3.95 billion.

How strong is Akzo Nobel’s balance sheet?

Zooming in on the latest balance sheet data, we can see that Akzo Nobel had liabilities of €5.57 billion due within 12 months and liabilities of €4.62 billion due beyond. In compensation for these obligations, it had cash of 1.37 billion euros as well as receivables worth 3.02 billion euros at less than 12 months. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables by €5.81 billion.

While that might sound like a lot, it’s not that bad because Akzo Nobel has a huge market capitalization of €12.3 billion, so it could probably bolster its balance sheet by raising capital if needed. But it is clear that it is essential to examine closely whether it can manage its debt without dilution.

We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). 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 ).

Akzo Nobel has a debt to EBITDA ratio of 3.7, which signals significant debt, but is still quite reasonable for most types of businesses. But its EBIT was around 12.3 times its interest expense, implying that the company isn’t really paying a high cost to maintain that level of leverage. Even if the low cost turns out to be unsustainable, that’s a good sign. Shareholders should know that Akzo Nobel’s EBIT fell 32% last year. If this earnings trend continues, paying off debt will be about as easy as herding cats on a roller coaster. There is no doubt that we learn the most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Akzo Nobel’s ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.

But our last consideration is also important, because a company cannot pay debt with paper profits; he needs cash. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Over the past three years, Akzo Nobel has recorded a free cash flow of 50% of its EBIT, which is lower than expected. This low cash conversion makes debt management more difficult.

Our point of view

Akzo Nobel’s EBIT growth rate and net debt to EBITDA are, in our view, weighing on him. But the good news is that it seems to be able to easily cover its interest costs with its EBIT. Considering the above factors, we believe that Akzo Nobel’s debt poses certain risks to the business. So even if this leverage increases return on equity, we wouldn’t really want to see it increase from now on. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks reside on the balance sheet, far from it. These risks can be difficult to spot. Every business has them, and we’ve spotted 3 warning signs for Akzo Nobel (1 of which can’t be ignored!) that you should know about.

If, after all that, you’re more interested in a fast-growing company with a strong balance sheet, check out our list of cash-flowing growth stocks without further ado.

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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.