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. 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. We can see that Namoi Cotton Limited (ASX:NAM) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Namoi Cotton Carry?
The image below, which you can click on for greater detail, shows that Namoi Cotton had debt of AU$42.1m at the end of February 2019, a reduction from AU$50.1m over a year. However, because it has a cash reserve of AU$5.83m, its net debt is less, at about AU$36.2m.
How Healthy Is Namoi Cotton's Balance Sheet?
We can see from the most recent balance sheet that Namoi Cotton had liabilities of AU$35.5m falling due within a year, and liabilities of AU$49.7m due beyond that. Offsetting this, it had AU$5.83m in cash and AU$3.97m in receivables that were due within 12 months. So its liabilities total AU$75.4m more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the AU$47.0m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet." So we'd watch its balance sheet closely, without a doubt After all, Namoi Cotton would likely require a major re-capitalisation if it had to pay its creditors today.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Namoi Cotton's net debt is sitting at a very reasonable 1.5 times its EBITDA, while its EBIT covered its interest expense just 6.5 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. But the other side of the story is that Namoi Cotton saw its EBIT decline by 4.0% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Namoi Cotton's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Namoi Cotton generated free cash flow amounting to a very robust 85% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
Namoi Cotton's level of total liabilities and EBIT growth rate definitely weigh on it, in our esteem. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Namoi Cotton's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
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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