Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Kongsberg Automotive ASA (OB:KOA) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Kongsberg Automotive Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Kongsberg Automotive had €280.2m of debt, an increase on €269.2m, over one year. However, because it has a cash reserve of €35.6m, its net debt is less, at about €244.6m.
OB:KOA Historical Debt, August 13th 2019
How Healthy Is Kongsberg Automotive's Balance Sheet?
According to the last reported balance sheet, Kongsberg Automotive had liabilities of €256.6m due within 12 months, and liabilities of €402.9m due beyond 12 months. Offsetting these obligations, it had cash of €35.6m as well as receivables valued at €278.8m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €345.1m.
When you consider that this deficiency exceeds the company's €269.0m market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner's social media. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Kongsberg Automotive's debt is 2.6 times its EBITDA, and its EBIT cover its interest expense 3.2 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. The good news is that Kongsberg Automotive grew its EBIT a smooth 50% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Kongsberg Automotive will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Kongsberg Automotive burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both Kongsberg Automotive's level of total liabilities and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, we think it's fair to say that Kongsberg Automotive has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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