Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. Above all, Akzo Nobel SA (AMS:AKZA) is in debt. But should shareholders worry about its use of debt?
Why is debt risky?
Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. If things go really bad, lenders can take over the business. However, a more common (but still costly) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
Discover our latest analysis for Akzo Nobel
What is Akzo Nobel’s debt?
As you can see below, at the end of March 2022, Akzo Nobel had 5.19 billion euros in debt, compared to 2.91 billion euros a year ago. Click on the image for more details. However, since it has a cash reserve of 2.50 billion euros, its net debt is less, at around 2.69 billion euros.
How strong is Akzo Nobel’s balance sheet?
We can see from the most recent balance sheet that Akzo Nobel had liabilities of €5.47 billion due in one year, and liabilities of €4.52 billion due beyond. On the other hand, it had 2.50 billion euros in cash and 2.74 billion euros in receivables at less than one year. Thus, its liabilities total 4.75 billion euros more than the combination of its cash and short-term receivables.
Akzo Nobel has a very large market capitalization of 14.1 billion euros, so it could very likely raise funds to improve its balance sheet, should the need arise. However, it is always worth taking a close look at its ability to repay debt.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
Akzo Nobel’s net debt to EBITDA ratio of around 2.1 suggests only moderate use of debt. And its strong interest coverage of 17.3 times puts us even more at ease. Unfortunately, Akzo Nobel’s EBIT actually fell 5.4% last year. If earnings continue to fall, managing that debt will be hard like delivering hot soup on a unicycle. There is no doubt that we learn the most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Akzo Nobel’s ability to maintain a healthy balance sheet in the future. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
Finally, a company can only repay its debts with cold hard cash, not with book profits. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Akzo Nobel has produced strong free cash flow equivalent to 61% of its EBIT, which is what we expected. This cold hard cash allows him to reduce his debt whenever he wants.
Our point of view
According to our analysis, Akzo Nobel’s interest coverage should signal that it won’t have too many problems with its debt. However, our other observations were not so encouraging. For example, it looks like it has to struggle a bit to increase its EBIT. Considering all of the elements mentioned above, it seems to us that Akzo Nobel manages its debt quite well. That said, the charge is heavy enough that we recommend that any shareholder keep a close eye on it. 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 outside of the balance sheet. Know that Akzo Nobel shows 2 warning signs in our investment analysis and 1 of them makes us a little uncomfortable…
In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.
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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.