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 synonymous with risk.” 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. We can see that Alfa Laval AB (publisher) (STO: ALFA) uses debt in its business. But the real question is whether this debt makes the business risky.
When is debt dangerous?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. If things go really bad, lenders can take over the business. 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.
Check out our latest analysis for Alfa Laval
What is Alfa Laval’s net debt?
The image below, which you can click on for more details, shows that Alfa Laval had a debt of 8.24 billion kr at the end of December 2021, a reduction from 9.40 billion kr year on year . However, he has 3.65 billion kr in cash to offset this, resulting in a net debt of around 4.60 billion kr.
A look at Alfa Laval’s responsibilities
According to the latest published balance sheet, Alfa Laval had liabilities of 23.3 billion kr due within 12 months and liabilities of 8.73 billion kr due beyond 12 months. As compensation for these obligations, it had liquid assets of 3.65 billion kr as well as receivables valued at 11.5 billion kr and payable within 12 months. Thus, its liabilities total kr 16.9 billion more than the combination of its cash and short-term receivables.
Given that publicly traded Alfa Laval shares are worth a very impressive total of 121.4 billion kr, it seems unlikely that this level of liability is a major threat. That said, it is clear that we must continue to monitor its record, lest it deteriorate.
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 ).
Alfa Laval has a low net debt to EBITDA ratio of just 0.56. And its EBIT easily covers its interest charges, which is 45.6 times the size. So we’re pretty relaxed about his super conservative use of debt. Alfa Laval’s EBIT has been fairly stable over the past year, but that shouldn’t be a problem given that it doesn’t have a lot of 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 Alfa Laval 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, while the taxman may love accounting profits, lenders only accept cash. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Over the past three years, Alfa Laval has produced strong free cash flow equivalent to 74% of its EBIT, which is what we expected. This cold hard cash allows him to reduce his debt whenever he wants.
Our point of view
Fortunately, Alfa Laval’s impressive interest coverage means it has the upper hand on its debt. And this is only the beginning of good news since its conversion of EBIT into free cash flow is also very pleasing. When we consider the range of factors above, it seems that Alfa Laval is quite sensible with its use of debt. This means they take on a bit more risk, hoping to increase shareholder returns. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks reside on the balance sheet, far from it. We have identified 2 warning signs with Alfa Laval, and understanding them should be part of your investment process.
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.