Here's Why National Tyre & Wheel (ASX:NTD) Can Manage Its Debt Responsibly

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.' 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 National Tyre & Wheel Limited (ASX:NTD) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for National Tyre & Wheel

What Is National Tyre & Wheel's Net Debt?

You can click the graphic below for the historical numbers, but it shows that National Tyre & Wheel had AU$12.2m of debt in June 2020, down from AU$13.1m, one year before. But it also has AU$25.9m in cash to offset that, meaning it has AU$13.6m net cash.

A Look At National Tyre & Wheel's Liabilities

Zooming in on the latest balance sheet data, we can see that National Tyre & Wheel had liabilities of AU$33.7m due within 12 months and liabilities of AU$22.6m due beyond that. Offsetting these obligations, it had cash of AU$25.9m as well as receivables valued at AU$23.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$7.28m.

Since publicly traded National Tyre & Wheel shares are worth a total of AU$108.5m, it seems unlikely that this level of liabilities would be a major 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, National Tyre & Wheel also has more cash than debt, so we're pretty confident it can manage its debt safely.

But the other side of the story is that National Tyre & Wheel saw its EBIT decline by 9.0% 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 ultimately the future profitability of the business will decide if National Tyre & Wheel 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 National Tyre & Wheel 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 three years, National Tyre & Wheel recorded free cash flow worth a fulsome 83% 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

We could understand if investors are concerned about National Tyre & Wheel's liabilities, but we can be reassured by the fact it has has net cash of AU$13.6m. The cherry on top was that in converted 83% of that EBIT to free cash flow, bringing in AU$14m. So is National Tyre & Wheel's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 4 warning signs for National Tyre & Wheel you should be aware of.

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.

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