Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say this when he says “The biggest risk in investing is not price volatility, but if you will suffer a loss. permanent capital “. When we think about how risky a business is, we always like to look at its use of debt because debt overload can lead to bankruptcy. We can see that Carlsberg A / S (CPH: CARL B) uses debt in his business. But does this debt worry shareholders?

When is debt dangerous?

Debts and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. While it’s not too common, we often see indebted companies continually diluting their shareholders because lenders are forcing them to raise capital at a ridiculous price. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. When we think of a business’s use of debt, we first look at cash flow and debt together.

See our latest review for Carlsberg

What is Carlsberg’s debt?

The graph below, which you can click for more details, shows that Carlsberg had a debt of 28.7 billion kr as of June 2021; about the same as the year before. However, he also had 8.38 billion crowns in cash, so his net debt is 20.3 billion crowns.

A look at Carlsberg’s responsibilities

The latest balance sheet data shows Carlsberg owed KKr 36.0 billion in debt due within one year, and KKr 44.9 billion in debt due thereafter. On the other hand, he had a treasury of 8.38 billion crowns and 10.8 billion crowns of receivables due within one year. Its liabilities therefore total 61.7 billion kroner more than the combination of its cash and short-term receivables.

Carlsberg has a very large market cap of NKr 149.0 billion, so it could very likely raise funds to improve its balance sheet, should the need arise. But we absolutely want to keep our eyes open for indications that its debt is too risky.

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 earnings before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). Thus, we look at debt versus earnings with and without amortization expenses.

Carlsberg’s net debt is only 1.5 times its EBITDA. And its EBIT easily covers its interest costs, being 22.5 times higher. We could therefore say that he is no more threatened by his debt than an elephant is by a mouse. Carlsberg’s EBIT was fairly stable over the past year, but that shouldn’t be a problem considering he doesn’t have a lot of debt. 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 Carlsberg can strengthen its 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 can only pay off its debts with hard cash, not with book profits. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Carlsberg has generated strong free cash flow equivalent to 73% of its EBIT, roughly what we expected. This hard cash allows him to reduce his debt whenever he wants.

Our point of view

Carlsberg’s interest coverage suggests he can manage his debt as easily as Cristiano Ronaldo could score a goal against an Under-14 keeper. And this is only the beginning of good news as its conversion from EBIT to free cash flow is also very encouraging. Looking at all of the aforementioned factors together, it seems to us that Carlsberg can manage his debt quite comfortably. Of course, while this leverage can improve returns on equity, it comes with more risk, so it’s worth keeping an eye out for. When analyzing debt levels, the balance sheet is the obvious place to start. However, not all investment risks lie on the balance sheet – far from it. Concrete example: we have spotted 1 warning sign for Carlsberg you must be aware.

At the end of the day, sometimes it’s easier to focus on businesses that don’t even need to go into debt. Readers can access a list of growth stocks with zero net debt 100% free, at present.

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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 any stock 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 has no position in any of the stocks mentioned.