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. Importantly, NZ Windfarms Limited (NZSE:NWF) does carry 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. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is NZ Windfarms's Debt?
As you can see below, NZ Windfarms had NZ$11.2m of debt at December 2018, down from NZ$12.3m a year prior. However, because it has a cash reserve of NZ$3.97m, its net debt is less, at about NZ$7.27m.
A Look At NZ Windfarms's Liabilities
The latest balance sheet data shows that NZ Windfarms had liabilities of NZ$2.85m due within a year, and liabilities of NZ$10.3m falling due after that. On the other hand, it had cash of NZ$3.97m and NZ$1.07m worth of receivables due within a year. So its liabilities total NZ$8.11m more than the combination of its cash and short-term receivables.
Given NZ Windfarms has a market capitalization of NZ$40.6m, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Even though NZ Windfarms's debt is only 1.9, its interest cover is really very low at 2.5. The main reason for this is that it has such high depreciation and amortisation. These charges may be non-cash, so they could be excluded when it comes to paying down debt. But the accounting charges are there for a reason -- some assets are seen to be losing value. Either way there's no doubt the stock is using meaningful leverage. Notably, NZ Windfarms made a loss at the EBIT level, last year, but improved that to positive EBIT of NZ$1.3m in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since NZ Windfarms will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, NZ Windfarms actually produced more free cash flow than EBIT over the last year. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
When it comes to the balance sheet, the standout positive for NZ Windfarms was the fact that it seems able to convert EBIT to free cash flow confidently. However, our other observations weren't so heartening. To be specific, it seems about as good at covering its interest expense with its EBIT as wet socks are at keeping your feet warm. Considering this range of data points, we think NZ Windfarms is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. Even though NZ Windfarms lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check outhow earnings have been trending over the last few years.
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.
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