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 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 AB Volvo (publisher) (STO: VOLV B) uses debt. But the real question is whether this debt makes the business risky.
When is debt a problem?
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. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. However, a more common (but still costly) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. By replacing dilution, however, debt can be a great tool for companies that need capital to invest in growth at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
Check out our latest analysis for AB Volvo
What is AB Volvo’s debt?
As you can see below, AB Volvo had 147.5 billion kr in debt, as of December 2021, which is about the same as the previous year. You can click on the graph for more details. However, he also had 62.3 billion kr in cash, so his net debt is 85.2 billion kr.
A look at AB Volvo’s responsibilities
According to the latest published balance sheet, AB Volvo had liabilities of 202.4 billion kr due within 12 months and liabilities of 169.3 billion kr due beyond 12 months. In return, he had 62.3 billion kr in cash and 59.3 billion kr in debt due within 12 months. Thus, its liabilities total 250.1 billion kr more than the combination of its cash and short-term receivables.
This deficit is considerable compared to its very large market capitalization of 374.6 billion kr, so it suggests shareholders to keep an eye on AB Volvo’s use of debt. 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). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
AB Volvo’s net debt to EBITDA ratio of around 1.7 suggests only moderate use of debt. And its towering EBIT of 53.3 times its interest expense means that the debt burden is as light as a peacock feather. On top of that, AB Volvo has grown its EBIT by 52% over the last twelve months, and this growth will help manage its debt. 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 AB Volvo’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, AB Volvo has recorded free cash flow of 36% of EBIT, which is lower than expected. This low cash conversion makes debt management more difficult.
Our point of view
AB Volvo’s ability to cover its interest charges with its EBIT and its EBIT growth rate has given us comfort in its ability to manage its debt. That said, its level of total liabilities makes us somewhat aware of potential future risks to the balance sheet. Given this range of data points, we believe that AB Volvo is in a good position to manage its level of debt. That said, the charge is heavy enough that we recommend that any shareholder keep a close eye on it. 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. For example, we found 2 warning signs for AB Volvo which you should be aware of before investing here.
In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.
Feedback on this article? Concerned about content? Get in touch with us directly. You can also email the editorial team (at) Simplywallst.com.
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.
Comments are closed.