Is AB Fagerhult (STO: FAG) a risky investment?

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Legendary fund manager Li Lu (who Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but the possibility that you will suffer a permanent loss of capital. So it seems like smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess the level of risk of a business. Like many other companies AB Fagerhult (STO: FAG) uses debt. But the most important question is: what risk does this debt create?

What risk does debt entail?

Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it exists at their mercy. Ultimately, if the company can’t meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still costly) situation is where a company has to dilute its shareholders at a cheap share price just to get its debt under control. By replacing dilution, however, debt can be a very good tool for companies 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 flow and debt together.

See our latest review for AB Fagerhult

What is AB Fagerhult’s debt?

As you can see below, AB Fagerhult had a debt of 3.72 billion kr in March 2021, up from 4.19 billion kr a year earlier. However, he also had 1.67 billion crowns in cash, so his net debt is 2.05 billion crowns.

OM: FAG History of debt on equity July 15, 2021

How healthy is AB Fagerhult’s balance sheet?

Zooming in on the latest balance sheet data, we can see that AB Fagerhult had a liability of SEK 1.73 billion due within 12 months and liabilities of SEK 4.88 billion beyond. In compensation for these obligations, he had cash of Kroner 1.67 billion as well as claims valued at Kroner 1.29 billion within 12 months. It therefore has liabilities totaling 3.65 billion crowns more than its combined cash and short-term receivables.

This deficit is not that bad because AB Fagerhult is worth 13.4 billion crowns, and could therefore probably raise enough capital to consolidate its balance sheet, if the need arose. But it is clear that it is absolutely necessary to take a close look at whether it can manage its debt without dilution.

We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). Thus, we consider debt versus earnings with and without amortization charges.

With a net debt on EBITDA of 2.6, AB Fagerhult has a fairly significant debt. On the positive side, its EBIT was 7.3 times its interest expense and its net debt to EBITDA was quite high, at 2.6. Shareholders should know that AB Fagerhult’s EBIT fell 30% last year. If this earnings trend continues, paying off debt will be about as easy as driving cats on a roller coaster. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether AB Fagerhult 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.

But our last consideration is also important, because a company cannot pay its debts with paper profits; he needs hard cash. It is therefore worth checking to what extent this EBIT is supported by free cash flow. Fortunately for all shareholders, AB Fagerhult has actually generated more free cash flow than EBIT over the past three years. There is nothing better than cash flow to stay in the good graces of your lenders.

Our point of view

AB Fagerhult’s EBIT growth rate was really negative in this analysis, although the other factors we considered were considerably better. In particular, we are dazzled by its conversion of EBIT into free cash flow. When we consider all of the factors mentioned above, we feel a little cautious about AB Fagerhult’s use of debt. While debt has its advantage in terms of potential higher returns, we think shareholders should definitely consider how leverage levels could make the stock riskier. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist off the balance sheet. Note that AB Fagerhult shows 3 warning signs in our investment analysis , and 1 of them is a bit rude …

At the end of the day, sometimes it’s easier to focus on businesses that don’t even need to go into debt. Readers can access a list of growth stocks with zero net debt 100% free, at present.

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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in the mentioned stocks.
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