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Is New Hope (ASX:NHC) A Risky Investment?

Simply Wall St

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, New Hope Corporation Limited (ASX:NHC) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for New Hope

How Much Debt Does New Hope Carry?

You can click the graphic below for the historical numbers, but it shows that as of January 2019 New Hope had AU$201.9m of debt, an increase on AU$11.4m, over one year. However, because it has a cash reserve of AU$106.5m, its net debt is less, at about AU$95.4m.

ASX:NHC Historical Debt, August 15th 2019

A Look At New Hope's Liabilities

Zooming in on the latest balance sheet data, we can see that New Hope had liabilities of AU$251.8m due within 12 months and liabilities of AU$461.3m due beyond that. Offsetting this, it had AU$106.5m in cash and AU$103.0m in receivables that were due within 12 months. So it has liabilities totalling AU$503.7m more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since New Hope has a market capitalization of AU$1.87b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

New Hope has a low net debt to EBITDA ratio of only 0.19. And its EBIT covers its interest expense a whopping 122 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In addition to that, we're happy to report that New Hope has boosted its EBIT by 48%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine New Hope's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, New Hope recorded free cash flow worth a fulsome 81% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

The good news is that New Hope'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 conversion of EBIT to free cash flow also supports that impression! Overall, we don't think New Hope is taking any bad risks, as its debt load seems modest. So the balance sheet looks pretty healthy, to us. Another factor that would give us confidence in New Hope would be if insiders have been buying shares: if you're conscious of that signal too, you can find out instantly 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.

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.