Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. As with many other companies Trelleborg AB (publ) (STO:TREL B) makes use of debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Trelleborg’s Debt?
The image below, which you can click on for greater detail, shows that at September 2022 Trelleborg had debt of kr12.3b, up from kr10.1b in one year. However, it also had kr2.75b in cash, and so its net debt is kr9.60b.
A Look At Trelleborg’s Liabilities
We can see from the most recent balance sheet that Trelleborg had liabilities of kr17.7b falling due within a year, and liabilities of kr10.9b due beyond that. Offsetting this, it had kr2.75b in cash and kr7.14b in receivables that were due within 12 months. So its liabilities total kr18.7b more than the combination of its cash and short-term receivables.
Trelleborg has a market capitalization of kr63.3b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Trelleborg has a low net debt to EBITDA ratio of only 1.3. And its EBIT easily covers its interest expense, being 23.6 times the size. So we’re pretty relaxed about its super-conservative use of debt. In addition to that, we’re happy to report that Trelleborg has boosted its EBIT by 46%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Trelleborg can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Trelleborg generated free cash flow amounting to a very robust 92% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.
Happily, Trelleborg’s impressive interest cover implies it has the upper hand on its debt. And that’s just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Zooming out, Trelleborg seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 2 warning signs we’ve spotted with Trelleborg (including 1 which is a bit unpleasant) .
At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.