U.S. Markets open in 6 hrs 44 mins

Neenah (NYSE:NP) Takes On Some Risk With Its Use Of Debt

Simply Wall St

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 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. We note that Neenah, Inc. (NYSE:NP) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

View our latest analysis for Neenah

What Is Neenah's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Neenah had US$223.7m of debt in June 2019, down from US$253.5m, one year before. On the flip side, it has US$8.10m in cash leading to net debt of about US$215.6m.

NYSE:NP Historical Debt, August 29th 2019

How Strong Is Neenah's Balance Sheet?

The latest balance sheet data shows that Neenah had liabilities of US$115.4m due within a year, and liabilities of US$335.8m falling due after that. On the other hand, it had cash of US$8.10m and US$123.6m worth of receivables due within a year. So its liabilities total US$319.5m more than the combination of its cash and short-term receivables.

Neenah has a market capitalization of US$1.09b, so it could very likely raise cash to ameliorate 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.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Neenah has net debt worth 2.0 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 5.7 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Shareholders should be aware that Neenah's EBIT was down 30% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Neenah'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Neenah produced sturdy free cash flow equating to 55% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Neenah's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. But on the bright side, its ability to convert EBIT to free cash flow isn't too shabby at all. When we consider all the factors discussed, it seems to us that Neenah is taking some risks with its use of debt. 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.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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.