New Hope (ASX:NHC) Seems To Use Debt Rather Sparingly

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.' 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 note that New Hope Corporation Limited (ASX:NHC) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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.

See our latest analysis for New Hope

What Is New Hope's Debt?

The image below, which you can click on for greater detail, shows that New Hope had debt of AU$188.8m at the end of January 2022, a reduction from AU$377.3m over a year. But it also has AU$513.1m in cash to offset that, meaning it has AU$324.3m net cash.

How Healthy Is New Hope's Balance Sheet?

The latest balance sheet data shows that New Hope had liabilities of AU$320.4m due within a year, and liabilities of AU$485.2m falling due after that. Offsetting these obligations, it had cash of AU$513.1m as well as receivables valued at AU$175.3m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$117.2m.

Since publicly traded New Hope shares are worth a total of AU$3.65b, 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. While it does have liabilities worth noting, New Hope also has more cash than debt, so we're pretty confident it can manage its debt safely.

Although New Hope made a loss at the EBIT level, last year, it was also good to see that it generated AU$721m in EBIT over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if New Hope can strengthen its balance sheet over time. 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. While New Hope 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. Over the last year, New Hope recorded free cash flow worth a fulsome 88% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Summing Up

While it is always sensible to look at a company's total liabilities, it is very reassuring that New Hope has AU$324.3m in net cash. And it impressed us with free cash flow of AU$637m, being 88% of its EBIT. So is New Hope's debt a risk? It doesn't seem so to us. 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. Case in point: We've spotted 1 warning sign for New Hope 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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.