Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. We can see that Fjord1 ASA (OB:FJORD) does use debt in its business. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
See our latest analysis for Fjord1
What Is Fjord1's Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Fjord1 had debt of kr3.92b, up from kr2.51b in one year. On the flip side, it has kr272.4m in cash leading to net debt of about kr3.65b.
How Strong Is Fjord1's Balance Sheet?
We can see from the most recent balance sheet that Fjord1 had liabilities of kr1.94b falling due within a year, and liabilities of kr3.32b due beyond that. Offsetting this, it had kr272.4m in cash and kr157.2m in receivables that were due within 12 months. So its liabilities total kr4.83b more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company's kr3.60b market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner's social media. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).