Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. Importantly, National Tyre & Wheel Limited (ASX:NTD) does carry debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is National Tyre & Wheel's Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2018 National Tyre & Wheel had AU$13.9m of debt, an increase on AU$7.68m, over one year. However, because it has a cash reserve of AU$13.6m, its net debt is less, at about AU$365.0k.
How Healthy Is National Tyre & Wheel's Balance Sheet?
We can see from the most recent balance sheet that National Tyre & Wheel had liabilities of AU$31.6m falling due within a year, and liabilities of AU$13.7m due beyond that. On the other hand, it had cash of AU$13.6m and AU$20.6m worth of receivables due within a year. So it has liabilities totalling AU$11.2m more than its cash and near-term receivables, combined.
This deficit isn't so bad because National Tyre & Wheel is worth AU$42.2m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. Carrying virtually no net debt, National Tyre & Wheel has a very light debt load indeed.
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.
With debt at a measly 0.023 times EBITDA and EBIT covering interest a whopping 23.5 times, it's clear that National Tyre & Wheel is not a desperate borrower. So relative to past earnings, the debt load seems trivial. On top of that, National Tyre & Wheel grew its EBIT by 45% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if National Tyre & Wheel 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, National Tyre & Wheel produced sturdy free cash flow equating to 60% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
The good news is that National Tyre & Wheel's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its EBIT growth rate also supports that impression! Zooming out, National Tyre & Wheel seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that National Tyre & Wheel insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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