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.' 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 Nick Scali Limited (ASX:NCK) does have debt on its balance sheet. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Nick Scali's Debt?
The chart below, which you can click on for greater detail, shows that Nick Scali had AU$33.7m in debt in June 2021; about the same as the year before. However, it does have AU$106.9m in cash offsetting this, leading to net cash of AU$73.2m.
How Healthy Is Nick Scali's Balance Sheet?
The latest balance sheet data shows that Nick Scali had liabilities of AU$136.0m due within a year, and liabilities of AU$186.8m falling due after that. Offsetting this, it had AU$106.9m in cash and AU$1.69m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$214.2m.
Given Nick Scali has a market capitalization of AU$1.19b, 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. While it does have liabilities worth noting, Nick Scali also has more cash than debt, so we're pretty confident it can manage its debt safely.
Better yet, Nick Scali grew its EBIT by 116% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. 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 Nick Scali's ability to maintain a healthy balance sheet going forward. 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. Nick Scali may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Nick Scali actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Although Nick Scali'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$73.2m. The cherry on top was that in converted 105% of that EBIT to free cash flow, bringing in AU$125m. So is Nick Scali's debt a risk? It doesn't seem so to us. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example - Nick Scali has 2 warning signs we think you should be aware of.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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.
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