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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. We note that NEXTDC Limited (ASX:NXT) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is NEXTDC's Net Debt?
As you can see below, NEXTDC had AU$798.2m of debt, at June 2020, which is about the same as the year before. You can click the chart for greater detail. But it also has AU$892.9m in cash to offset that, meaning it has AU$94.7m net cash.
How Healthy Is NEXTDC's Balance Sheet?
According to the last reported balance sheet, NEXTDC had liabilities of AU$378.8m due within 12 months, and liabilities of AU$597.3m due beyond 12 months. On the other hand, it had cash of AU$892.9m and AU$45.1m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$38.1m.
This state of affairs indicates that NEXTDC's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the AU$5.21b company is struggling for cash, we still think it's worth monitoring its balance sheet. While it does have liabilities worth noting, NEXTDC also has more cash than debt, so we're pretty confident it can manage its debt safely.
NEXTDC grew its EBIT by 7.1% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if NEXTDC 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. NEXTDC may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, NEXTDC burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
We could understand if investors are concerned about NEXTDC's liabilities, but we can be reassured by the fact it has has net cash of AU$94.7m. And it also grew its EBIT by 7.1% over the last year. So although we see some areas for improvement, we're not too worried about NEXTDC's balance sheet. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider risks, for instance. Every company has them, and we've spotted 1 warning sign for NEXTDC you should know about.
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.
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. 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.
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