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. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. We note that AdderaCare AB (STO:ADDERA) has debt on its balance sheet. But the more important question is: what risk does this debt create?
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. Of course, many companies use debt to finance their growth, without any negative consequences. The first thing to do when considering how much debt a business has is to look at its cash and debt together.
Check out our latest analysis for AdderaCare
What is AdderaCare’s debt?
You can click on the graph below for historical figures, but it shows that in March 2022, AdderaCare had 39.7 million kr in debt, an increase from 29.1 million kr, year on year. However, he also had 14.8 million kr in cash, so his net debt is 24.8 million kr.
How strong is AdderaCare’s balance sheet?
Zooming in on the latest balance sheet data, we can see that AdderaCare had liabilities of 93.2 million kr due within 12 months and liabilities of 36.7 million kr due beyond. In return, it had 14.8 million kr in cash and 30.1 million kr in receivables due within 12 months. It therefore has liabilities totaling kr 85.0 million more than its cash and short-term receivables, combined.
This is a mountain of leverage compared to its market capitalization of 87.0 million kr. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet quickly.
In order to assess a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its earnings before interest and taxes (EBIT) divided by its expenses. interest (its 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 ).
Looking at its net debt to EBITDA ratio of 1.4 and its interest coverage of 4.5 times, it seems to us that AdderaCare is probably using debt quite sensibly. We therefore recommend that you closely monitor the impact of financing costs on the company. Fortunately, AdderaCare is growing its EBIT faster than former Australian Prime Minister Bob Hawke dropped a yard glass, with a 269% gain over the last twelve months. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether AdderaCare 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 company can only repay its debts with cold hard cash, not with book profits. It is therefore worth checking how much of this EBIT is supported by free cash flow. Over the past two years, AdderaCare has actually produced more free cash flow than EBIT. This kind of high cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Our point of view
Fortunately, AdderaCare’s impressive EBIT to free cash flow conversion means it has the upper hand on its debt. But we have to admit that we find that his level of total liabilities has the opposite effect. It should also be noted that AdderaCare is in the medical device industry, which is often seen as quite defensive. All told, it looks like AdderaCare can comfortably handle its current level of debt. Of course, while this leverage can improve return on equity, it comes with more risk, so it’s worth keeping an eye out for. The balance sheet is clearly the area to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist outside of the balance sheet. For example, we have identified 4 Warning Signs for AdderaCare (2 are concerning) that you should be aware of.
Of course, if you’re the type of investor who prefers to buy stocks without the burden of debt, then feel free to check out our exclusive list of cash-efficient growth stocks today.
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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.