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These 4 Measures Indicate That North West (TSE:NWC) Is Using Debt Extensively

Simply Wall St

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that The North West Company Inc. (TSE:NWC) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for North West

What Is North West's Net Debt?

As you can see below, at the end of April 2019, North West had CA$408.1m of debt, up from CA$354.2m a year ago. Click the image for more detail. However, it also had CA$63.4m in cash, and so its net debt is CA$344.6m.

TSX:NWC Historical Debt, August 17th 2019

How Healthy Is North West's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that North West had liabilities of CA$191.9m due within 12 months and liabilities of CA$577.4m due beyond that. Offsetting this, it had CA$63.4m in cash and CA$89.1m in receivables that were due within 12 months. So it has liabilities totalling CA$616.7m more than its cash and near-term receivables, combined.

This deficit isn't so bad because North West is worth CA$1.49b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

North West's net debt of 2.0 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 7.9 times interest expense) certainly does not do anything to dispel this impression. Unfortunately, North West saw its EBIT slide 9.1% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if North West 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, North West recorded free cash flow of 32% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

North West's EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability to cover its interest expense with its EBIT isn't too shabby at all. When we consider all the factors discussed, it seems to us that North West is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. Given North West has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.