Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. Like many other companies Barns AB (pub) (STO:GRNG) uses debt. But the real question is whether this debt makes the business risky.
When is debt dangerous?
Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. By replacing dilution, however, debt can be a great tool for companies that need capital to invest in growth at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
See our latest analysis for Gränges
What is Gränges’ net debt?
The image below, which you can click on for more details, shows that in March 2022, Gränges had a debt of 5.10 billion kr, compared to 3.76 billion kr in one year. However, he also had 655.0 million kr in cash, so his net debt is 4.45 billion kr.
A look at the responsibilities of Gränges
Zooming in on the latest balance sheet data, we can see that Gränges had liabilities of 7.19 billion kr due within 12 months and liabilities of 3.63 billion kr due beyond. In return, he had 655.0 million kr in cash and 3.72 billion kr in debt due within 12 months. Thus, its liabilities total kr 6.45 billion more than the combination of its cash and short-term receivables.
This deficit is considerable compared to its market capitalization of 8.59 billion kr, so it suggests that shareholders monitor the use of debt by Gränges. If its lenders asked it to shore up its balance sheet, shareholders would likely face significant 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). Thus, we consider debt to earnings with and without amortization and depreciation expense.
Gränges’ net debt is 2.7 times its EBITDA, which represents significant but still reasonable leverage. But its EBIT was around 13.8 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. It should be noted that Gränges’ EBIT has jumped like bamboo after the rain, gaining 41% over the last twelve months. This will make it easier to manage your debt. 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 Gränges can strengthen its balance sheet over time. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
But our last consideration is also important, because a company cannot pay debt with paper profits; he needs cash. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Gränges has actually seen a cash outflow, overall. Debt is generally more expensive and almost always riskier in the hands of a company with negative free cash flow. Shareholders should hope for an improvement.
Our point of view
While Gränges’ conversion of EBIT to free cash flow makes us nervous. For example, its interest coverage and EBIT growth rate give us some confidence in its ability to manage its debt. We think Gränges’ debt makes it a bit risky, after looking at the aforementioned data points together. This isn’t necessarily a bad thing, since leverage can increase return on equity, but it is something to be aware of. 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 outside of the balance sheet. These risks can be difficult to spot. Every business has them, and we’ve spotted 4 warning signs for Gränges (of which 1 does not suit us too much!) that you should know.
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.