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The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Northern Technologies International Corporation (NASDAQ:NTIC) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Northern Technologies International's Debt?
As you can see below, at the end of February 2022, Northern Technologies International had US$4.20m of debt, up from none a year ago. Click the image for more detail. But on the other hand it also has US$7.49m in cash, leading to a US$3.29m net cash position.
How Healthy Is Northern Technologies International's Balance Sheet?
The latest balance sheet data shows that Northern Technologies International had liabilities of US$13.3m due within a year, and liabilities of US$2.24m falling due after that. Offsetting these obligations, it had cash of US$7.49m as well as receivables valued at US$15.0m due within 12 months. So it can boast US$6.99m more liquid assets than total liabilities.
This short term liquidity is a sign that Northern Technologies International could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Northern Technologies International has more cash than debt is arguably a good indication that it can manage its debt safely.
It was also good to see that despite losing money on the EBIT line last year, Northern Technologies International turned things around in the last 12 months, delivering and EBIT of US$648k. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Northern Technologies International can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Northern Technologies 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. Over the last year, Northern Technologies International saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
While it is always sensible to investigate a company's debt, in this case Northern Technologies International has US$3.29m in net cash and a decent-looking balance sheet. So we don't have any problem with Northern Technologies International's use of debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 4 warning signs for Northern Technologies International that you should be aware of.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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.