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Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from risk.” When we think about how risky a business is, we always like to look at its use of debt because debt overload can lead to bankruptcy. Like many other companies Sweco AB (editor) (STO: SWEC B) uses debt. But the most important question is: what risk does this debt create?
What risk does debt entail?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it exists at their mercy. If things really go wrong, lenders can take over the business. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. That said, the most common situation is where a business manages its debt reasonably well – and to its own advantage. The first step in examining a company’s debt levels is to consider its cash flow and debt together.
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What is Sweco’s debt?
The image below, which you can click for more details, shows Sweco owed Kroner 2.42 billion at the end of June 2021, down from Kroner 3.15 billion on a year. However, he has 475.0 million kr in cash to compensate for this, which leads to a net debt of around 1.94 billion kr.
A look at Sweco’s responsibilities
Zooming in on the latest balance sheet data, we can see that Sweco had a liability of 6.84 billion kr due within 12 months and a liability of 5.00 billion kr due thereafter. In compensation for these obligations, it had cash of kr 475.0 million as well as receivables valued at kr 7.33 billion due within 12 months. It therefore has liabilities totaling 4.04 billion crowns more than its combined cash and short-term receivables.
Considering that Sweco’s publicly traded shares are worth a total of SEK 49.5 billion, it seems unlikely that this level of liabilities is a major threat. But there are enough liabilities that we would certainly recommend that shareholders continue to monitor the balance sheet going forward.
We use two main ratios to tell us about leverage versus earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). Thus, we consider debt versus earnings with and without amortization charges.
Sweco has a low net debt / EBITDA ratio of just 0.90. And its EBIT covers its interest costs a whopping 24.3 times. So we’re pretty relaxed about its ultra-conservative use of debt. On the other hand, Sweco’s EBIT has plunged 12% over the past year. If this rate of decline in profits continues, the company could find itself in a difficult situation. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether Sweco can strengthen its balance sheet over time. So, if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, a business needs free cash flow to pay off debts; accounting profits are not enough. We therefore always check how much of this EBIT is converted into free cash flow. In the past three years, Sweco has actually generated more free cash flow than EBIT. This kind of cash conversion makes us as excited as the crowd when the pace drops at a Daft Punk concert.
Our point of view
Fortunately, Sweco’s impressive interest coverage means it has the upper hand on its debt. But we have to admit that we find that its growth rate of EBIT has the opposite effect. Considering all of this data, it seems to us that Sweco has a pretty sane approach to debt. While this carries some risk, it can also improve returns for shareholders. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist off the balance sheet. Be aware that Sweco shows 1 warning sign in our investment analysis , you must know…
At the end of the day, it’s often best to focus on businesses with no net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.
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