Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Northwest Natural Holding Company (NYSE:NWN) makes use of debt. But should shareholders be worried about its use of debt?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Northwest Natural Holding Carry?
As you can see below, at the end of June 2019, Northwest Natural Holding had US$930.5m of debt, up from US$805.8m a year ago. Click the image for more detail. On the flip side, it has US$60.9m in cash leading to net debt of about US$869.6m.
How Strong Is Northwest Natural Holding's Balance Sheet?
We can see from the most recent balance sheet that Northwest Natural Holding had liabilities of US$307.0m falling due within a year, and liabilities of US$2.05b due beyond that. Offsetting these obligations, it had cash of US$60.9m as well as receivables valued at US$56.7m due within 12 months. So it has liabilities totalling US$2.24b more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's market capitalization of US$2.10b, we think shareholders really should watch Northwest Natural Holding's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Northwest Natural Holding's debt is 3.4 times its EBITDA, and its EBIT cover its interest expense 3.7 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. However, one redeeming factor is that Northwest Natural Holding grew its EBIT at 19% over the last 12 months, boosting its ability to handle its 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 Northwest Natural Holding 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 it's worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, Northwest Natural Holding actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for and improvement.
We'd go so far as to say Northwest Natural Holding's conversion of EBIT to free cash flow was disappointing. But at least it's pretty decent at growing its EBIT; that's encouraging. We should also note that Gas Utilities industry companies like Northwest Natural Holding commonly do use debt without problems. Looking at the bigger picture, it seems clear to us that Northwest Natural Holding's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. Over time, share prices tend to follow earnings per share, so if you're interested in Northwest Natural Holding, you may well want to click here to check an interactive graph of its earnings per share history.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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 email@example.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.