Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from risk.” So it can be obvious that you need to consider debt, when you think about how risky a given stock is, because too much debt can sink a business. We can see that Kesko Oyj (HEL: KESKOB) uses debt in his business. But does this debt concern shareholders?

When is debt dangerous?

Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. In the worst case scenario, a business can go bankrupt if it cannot pay its creditors. 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. That said, the most common situation is where a business manages its debt reasonably well – and to its own advantage. When we think of a business’s use of debt, we first look at cash flow and debt together.

See our latest review for Kesko Oyj

What is Kesko Oyj’s net debt?

You can click on the graph below for the historical figures, but it shows that Kesko Oyj had € 561.0 million in debt in June 2021, up from € 791.9 million a year earlier. However, he also had 366.7 million euros in cash, so his net debt is 194.3 million euros.

How healthy is Kesko Oyj’s track record?

According to the latest published balance sheet, Kesko Oyj had liabilities of 2.83 billion euros at 12 months and liabilities of 2.05 billion euros over 12 months. In compensation for these commitments, he had cash of € 366.7 million as well as receivables valued at € 1.36 billion within 12 months. It therefore has total liabilities of 3.16 billion euros more than its combined cash and short-term receivables.

This deficit is not that big as Kesko Oyj is worth 12.3 billion euros and could therefore probably raise enough capital to consolidate his balance sheet, should the need arise. However, it is always worth taking a close look at your ability to repay your debt.

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 net debt of just 0.23 times EBITDA, Kesko Oyj is arguably fairly cautious. And this view is supported by the strong interest coverage, with EBIT reaching 9.8 times last year’s interest expense. On top of that, Kesko Oyj has increased its EBIT by 33% over the past twelve months, and this growth will make it easier to process its debt. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, the future profitability of the business will decide whether Kesko Oyj can strengthen his balance sheet over time. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.

Finally, a business needs free cash flow to repay its debts; accounting profits are not enough. It is therefore worth checking to what extent this EBIT is supported by free cash flow. Over the past three years, Kesko Oyj has actually generated more free cash flow than EBIT. This kind of solid money conversion makes us as excited as the crowd when the beat drops at a Daft Punk concert.

Our point of view

Kesko Oyj’s conversion of EBIT to free cash flow suggests he can manage his debt as easily as Cristiano Ronaldo could score a goal against an Under-14 goalkeeper. And that’s just the start of the good news as its EBIT growth rate is also very encouraging. Overall, we don’t think Kesko Oyj is taking bad risks, as his leverage appears modest. We are therefore not worried about the use of a small leverage on the balance sheet. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks lie on the balance sheet – far from it. We have identified 2 warning signs with Kesko Oyj (at least 1 of concern), and understanding them should be part of your investment process.

At the end of the day, it’s often best to focus on businesses with no net debt. You can access our special list of these companies (all with a history of profit 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 using only unbiased methodology and our articles are not intended to be financial advice. 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 documents. Simply Wall St does not have any position in the mentioned stocks.
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