David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital. It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that New Hope Corporation Limited (ASX:NHC) does use debt in its business. But the more important question is: how much risk is that debt creating?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is New Hope’s Debt?
You can click the graphic below for the historical numbers, but it shows that as of January 2020 New Hope had AU$421.0m of debt, an increase on AU$201.9m, over one year. However, it also had AU$61.0m in cash, and so its net debt is AU$360.0m.
A Look At New Hope’s Liabilities
Zooming in on the latest balance sheet data, we can see that New Hope had liabilities of AU$169.5m due within 12 months and liabilities of AU$742.2m due beyond that. Offsetting these obligations, it had cash of AU$61.0m as well as receivables valued at AU$122.6m due within 12 months. So its liabilities total AU$728.1m more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of AU$848.3m, so it does suggest shareholders should keep an eye on New Hope’s use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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.
New Hope has a low net debt to EBITDA ratio of only 0.90. And its EBIT easily covers its interest expense, being 17.4 times the size. So we’re pretty relaxed about its super-conservative use of debt. The modesty of its debt load may become crucial for New Hope if management cannot prevent a repeat of the 34% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine New Hope’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, New Hope recorded free cash flow worth 75% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
We feel some trepidation about New Hope’s difficulty EBIT growth rate, but we’ve got positives to focus on, too. To wit both its interest cover and conversion of EBIT to free cash flow were encouraging signs. Looking at all the angles mentioned above, it does seem to us that New Hope is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it. For example, we’ve discovered 2 warning signs for New Hope that you should be aware of before investing here.
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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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