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. We note that South Port New Zealand Limited (NZSE:SPN) does have debt on its balance sheet. 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. If things get really bad, the lenders can take control of the business. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does South Port New Zealand Carry?
The image below, which you can click on for greater detail, shows that South Port New Zealand had debt of NZ$7.25m at the end of June 2020, a reduction from NZ$7.60m over a year. However, because it has a cash reserve of NZ$1.23m, its net debt is less, at about NZ$6.02m.
A Look At South Port New Zealand’s Liabilities
We can see from the most recent balance sheet that South Port New Zealand had liabilities of NZ$7.66m falling due within a year, and liabilities of NZ$6.12m due beyond that. Offsetting this, it had NZ$1.23m in cash and NZ$6.46m in receivables that were due within 12 months. So it has liabilities totalling NZ$6.1m more than its cash and near-term receivables, combined.
Given South Port New Zealand has a market capitalization of NZ$164.2m, it’s hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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.
South Port New Zealand has a low net debt to EBITDA ratio of only 0.34. And its EBIT easily covers its interest expense, being 24.9 times the size. So we’re pretty relaxed about its super-conservative use of debt. But the other side of the story is that South Port New Zealand saw its EBIT decline by 3.5% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since South Port New Zealand 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, South Port New Zealand produced sturdy free cash flow equating to 54% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
South Port New Zealand’s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. But, on a more sombre note, we are a little concerned by its EBIT growth rate. It’s also worth noting that South Port New Zealand is in the Infrastructure industry, which is often considered to be quite defensive. When we consider the range of factors above, it looks like South Port New Zealand is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. Given South Port New Zealand has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
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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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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