Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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. As with many other companies NRW Holdings Limited (ASX:NWH) makes use of debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is NRW Holdings's Net Debt?
You can click the graphic below for the historical numbers, but it shows that NRW Holdings had AU$27.0m of debt in December 2020, down from AU$64.1m, one year before. However, its balance sheet shows it holds AU$171.4m in cash, so it actually has AU$144.4m net cash.
How Healthy Is NRW Holdings' Balance Sheet?
According to the last reported balance sheet, NRW Holdings had liabilities of AU$461.5m due within 12 months, and liabilities of AU$219.2m due beyond 12 months. Offsetting these obligations, it had cash of AU$171.4m as well as receivables valued at AU$337.8m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$171.4m.
Since publicly traded NRW Holdings shares are worth a total of AU$976.1m, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, NRW Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!
NRW Holdings's EBIT was pretty flat over the last year, but that shouldn't be an issue given the it doesn't have a lot of debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if NRW Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While NRW Holdings 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. During the last three years, NRW Holdings generated free cash flow amounting to a very robust 92% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
Although NRW Holdings's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of AU$144.4m. The cherry on top was that in converted 92% of that EBIT to free cash flow, bringing in AU$145m. So we are not troubled with NRW Holdings's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example - NRW Holdings has 3 warning signs we think you should be aware of.
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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