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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies NOW Inc. (NYSE:DNOW) makes use of debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is NOW's Net Debt?
The image below, which you can click on for greater detail, shows that NOW had debt of US$62.0m at the end of June 2019, a reduction from US$195.0m over a year. But on the other hand it also has US$80.0m in cash, leading to a US$18.0m net cash position.
How Healthy Is NOW's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that NOW had liabilities of US$468.0m due within 12 months and liabilities of US$117.0m due beyond that. On the other hand, it had cash of US$80.0m and US$496.0m worth of receivables due within a year. So these liquid assets roughly match the total liabilities.
This state of affairs indicates that NOW's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the US$1.32b company is struggling for cash, we still think it's worth monitoring its balance sheet. While it does have liabilities worth noting, NOW also has more cash than debt, so we're pretty confident it can manage its debt safely.
Better yet, NOW grew its EBIT by 363% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine NOW'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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. While NOW has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the most recent two years, NOW recorded free cash flow worth 60% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While it is always sensible to look at a company's total liabilities, it is very reassuring that NOW has US$18.0m in net cash. And we liked the look of last year's 363% year-on-year EBIT growth. So we don't think NOW's use of debt is risky. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of NOW's earnings per share history for free.
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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