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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. As with many other companies Natural Alternatives International, Inc. (NASDAQ:NAII) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. If things get really bad, the lenders can take control of the business. 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.
What Is Natural Alternatives International's Net Debt?
The chart below, which you can click on for greater detail, shows that Natural Alternatives International had US$10.0m in debt in September 2021; about the same as the year before. But it also has US$20.0m in cash to offset that, meaning it has US$10.0m net cash.
A Look At Natural Alternatives International's Liabilities
According to the last reported balance sheet, Natural Alternatives International had liabilities of US$20.6m due within 12 months, and liabilities of US$27.0m due beyond 12 months. On the other hand, it had cash of US$20.0m and US$20.2m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$7.39m.
Since publicly traded Natural Alternatives International shares are worth a total of US$85.9m, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, Natural Alternatives International also has more cash than debt, so we're pretty confident it can manage its debt safely.
Better yet, Natural Alternatives International grew its EBIT by 649% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. There's no doubt that we learn most about debt from the balance sheet. But it is Natural Alternatives International's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Natural Alternatives International has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Natural Alternatives International burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
We could understand if investors are concerned about Natural Alternatives International's liabilities, but we can be reassured by the fact it has has net cash of US$10.0m. And it impressed us with its EBIT growth of 649% over the last year. So we are not troubled with Natural Alternatives International's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Natural Alternatives International (of which 2 are a bit unpleasant!) you should know about.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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.