Is Elkem (OB:ELK) a risky investment?
Warren Buffett said: “Volatility is far from synonymous with risk. So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. We can see that Elkem ASA (OB:ELK) uses debt in its business. But the real question is whether this debt makes the business risky.
When is debt a problem?
Debt helps a business until the business struggles to pay it back, either with new capital or with free 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. By replacing dilution, however, debt can be a great tool for companies 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.
See our latest analysis for Elkem
What is Elkem’s debt?
The image below, which you can click on for more details, shows that in December 2021, Elkem had a debt of 11.7 billion kr, compared to 10.9 billion kr in one year. However, he has 7.04 billion kr in cash to offset this, resulting in a net debt of approximately 4.69 billion kr.
How strong is Elkem’s balance sheet?
According to the latest published balance sheet, Elkem had liabilities of kr 12.3 billion maturing within 12 months and liabilities of kr 9.72 billion maturing beyond 12 months. In return, he had 7.04 billion kr in cash and 5.18 billion kr in debt due within 12 months. It therefore has liabilities totaling kr 9.75 billion more than its cash and short-term receivables, combined.
Elkem has a market capitalization of 23.9 billion kr, so it could very likely raise funds to improve its balance sheet, should the need arise. But we definitely want to keep our eyes peeled for indications that its debt is too risky.
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 ).
Elkem has a low net debt to EBITDA ratio of just 0.64. And its EBIT easily covers its interest costs, which is 26.8 times the size. One could therefore say that he is no more threatened by his debt than an elephant is by a mouse. What is even more impressive is that Elkem increased its EBIT by 486% year-over-year. If sustained, this growth will make debt even more manageable in years to come. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether Elkem can strengthen its balance sheet over time. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
Finally, while the taxman may love accounting profits, lenders only accept cash. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Elkem has created free cash flow of 14% of its EBIT, an uninspiring performance. For us, such a low cash conversion creates a bit of paranoia about the ability to extinguish the debt.
Our point of view
Elkem’s interest coverage suggests he can manage his debt as easily as Cristiano Ronaldo could score a goal against an Under-14 keeper. But, on a darker note, we are a bit concerned about its conversion of EBIT into free cash flow. All in all, it looks like Elkem can comfortably manage its current level of debt. Of course, while this leverage can improve return on equity, it comes with more risk, so it’s worth keeping an eye out for. 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. For example, we have identified 5 warning signs for Elkem (1 is significant) which you should be aware of.
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.