Howard Marks said it well when he said that, rather than worrying about stock price volatility, “the possibility of permanent loss is the risk I worry about…and that every practical investor that I know is worried”. It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. We notice that SkiStar AB (publisher) (STO:SKIS B) has a debt on its balance sheet. But the real question is whether this debt makes the business risky.
Why is debt risky?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. In the worst case, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) event is when a company has to issue shares at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, many companies use debt to finance their growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.
Check out our latest analysis for SkiStar
What is SkiStar’s debt?
As you can see below, SkiStar had 1.63 billion kr in debt in November 2021, compared to 1.98 billion kr the previous year. However, as it has a cash reserve of 98.9 million kr, its net debt is lower at around 1.53 billion kr.
A Look at SkiStar’s Responsibilities
We can see from the most recent balance sheet that SkiStar had liabilities of 2.11 billion kr due in one year, and liabilities of 2.57 billion kr due beyond. In return, he had 98.9 million kr in cash and 193.0 million kr in receivables due within 12 months. Thus, its liabilities total 4.38 billion kr more than the combination of its cash and short-term receivables.
This shortfall is not that bad as SkiStar is worth 11.5 billion kr, and therefore could probably raise enough capital to shore up its balance sheet, should the need arise. But it is clear that it is essential to examine closely whether it can manage its debt without dilution.
We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
SkiStar has a debt to EBITDA ratio of 2.9 and its EBIT covered its interest expense 5.6 times. This suggests that while debt levels are significant, we will refrain from labeling them as problematic. Importantly, SkiStar’s EBIT has fallen by 45% over the last twelve months. If this earnings trend continues, paying off debt will be about as easy as herding 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 SkiStar 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, a business needs free cash flow to pay off its debts; book profits are not enough. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, SkiStar has recorded a free cash flow of 45% of its EBIT, which is lower than expected. This low cash conversion makes debt management more difficult.
Our point of view
We would go so far as to say that SkiStar’s EBIT growth rate is disappointing. That said, its ability to cover its interest costs with its EBIT is not so worrying. Once we consider all of the above factors together, it seems to us that SkiStar’s debt makes it a bit risky. This isn’t necessarily a bad thing, but we would generally feel more comfortable with less leverage. The balance sheet is clearly the area to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist outside of the balance sheet. To this end, you should be aware of the 4 warning signs we spotted with SkiStar.
If, after all that, you’re more interested in a fast-growing company with a strong balance sheet, check out our list of cash-neutral growth stocks right away.
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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.