David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Sanoma Oyj (HELL:SANOMA) makes use of debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.
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How Much Debt Does Sanoma Oyj Carry?
You can click the graphic below for the historical numbers, but it shows that as of September 2022 Sanoma Oyj had €790.3m of debt, an increase on €515.4m, over one year. However, because it has a cash reserve of €114.4m, its net debt is less, at about €675.9m.
How Strong Is Sanoma Oyj’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Sanoma Oyj had liabilities of €819.3m due within 12 months and liabilities of €829.5m due beyond that. Offsetting this, it had €114.4m in cash and €349.3m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €1.19b.
This deficit is quite relative to its market capitalization of €1.63b, so it does suggest shareholders should keep an eye on Sanoma Oyj’s use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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.
Sanoma Oyj has a debt to EBITDA ratio of 2.8, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 14.3 times its interest expense, implying the company isn’t really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. We also note that Sanoma Oyj improved its EBIT from a last year’s loss to a positive €122m. When analyzing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Sanoma Oyj can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Sanoma Oyj generated free cash flow amounting to a very robust 84% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.
Both Sanoma Oyj’s ability to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. On the other hand, its level of total liabilities makes us a little less comfortable about its debt. When we consider all the elements mentioned above, it seems to us that Sanoma Oyj is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. The balance sheet is clearly the area to focus on when you are analyzing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We’ve identified 2 warning signs with Sanoma Oyj (at least 1 which is a bit unpleasant) and understanding them should be part of your investment process.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% freeright now.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.