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. 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 can see that Nuance Communications, Inc. (NASDAQ:NUAN) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Nuance Communications's Debt?
You can click the graphic below for the historical numbers, but it shows that Nuance Communications had US$1.92b of debt in June 2019, down from US$2.32b, one year before. On the flip side, it has US$673.4m in cash leading to net debt of about US$1.25b.
A Look At Nuance Communications's Liabilities
According to the last reported balance sheet, Nuance Communications had liabilities of US$668.0m due within 12 months, and liabilities of US$2.48b due beyond 12 months. On the other hand, it had cash of US$673.4m and US$381.8m worth of receivables due within a year. So it has liabilities totalling US$2.09b more than its cash and near-term receivables, combined.
Nuance Communications has a market capitalization of US$4.55b, 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While Nuance Communications's debt to EBITDA ratio (2.9) suggests that it uses some debt, its interest cover is very weak, at 2.3, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. The silver lining is that Nuance Communications grew its EBIT by 225% last year, which nourishing like the idealism of youth. If it can keep walking that path it will be in a position to shed its debt with relative ease. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Nuance Communications'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. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Nuance Communications actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
The good news is that Nuance Communications's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But we must concede we find its interest cover has the opposite effect. All these things considered, it appears that Nuance Communications can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Nuance Communications insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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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