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.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Kongsberg Automotive ASA (OB:KOA) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. 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. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Kongsberg Automotive’s Debt?
The chart below, which you can click on for greater detail, shows that Kongsberg Automotive had €273.4m in debt in December 2020; about the same as the year before. On the flip side, it has €67.4m in cash leading to net debt of about €206.0m.
How Healthy Is Kongsberg Automotive’s Balance Sheet?
We can see from the most recent balance sheet that Kongsberg Automotive had liabilities of €253.2m falling due within a year, and liabilities of €399.3m due beyond that. Offsetting this, it had €67.4m in cash and €272.8m in receivables that were due within 12 months. So its liabilities total €312.3m more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company’s €295.4m market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While Kongsberg Automotive’s debt to EBITDA ratio (3.9) suggests that it uses some debt, its interest cover is very weak, at 0.98, suggesting high leverage. In large part that’s due to the company’s significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Even worse, Kongsberg Automotive saw its EBIT tank 67% over the last 12 months. If earnings keep going like that over the long term, it has a snowball’s chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Kongsberg Automotive’s earnings that will influence how the balance sheet holds up in the future. So if you’re keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Considering the last three years, Kongsberg Automotive actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.
To be frank both Kongsberg Automotive’s interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And furthermore, its level of total liabilities also fails to instill confidence. Taking into account all the aforementioned factors, it looks like Kongsberg Automotive has too much debt. While some investors…