Here's Why National Tyre & Wheel (ASX:NTD) Has A Meaningful Debt Burden

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 can see that National Tyre & Wheel Limited (ASX:NTD) does use debt in its business. But the real question is whether this debt is making the company risky.

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for National Tyre & Wheel

What Is National Tyre & Wheel's Net Debt?

As you can see below, National Tyre & Wheel had AU$94.3m of debt, at December 2023, which is about the same as the year before. You can click the chart for greater detail. However, it also had AU$31.2m in cash, and so its net debt is AU$63.1m.

A Look At National Tyre & Wheel's Liabilities

The latest balance sheet data shows that National Tyre & Wheel had liabilities of AU$106.4m due within a year, and liabilities of AU$151.3m falling due after that. Offsetting this, it had AU$31.2m in cash and AU$66.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$159.6m.

The deficiency here weighs heavily on the AU$73.8m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, National Tyre & Wheel would probably need a major re-capitalization if its creditors were to demand repayment.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

While we wouldn't worry about National Tyre & Wheel's net debt to EBITDA ratio of 2.7, we think its super-low interest cover of 1.8 times is a sign of high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. The good news is that National Tyre & Wheel grew its EBIT a smooth 48% over the last twelve months. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since National Tyre & Wheel 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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, National Tyre & Wheel produced sturdy free cash flow equating to 78% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

We feel some trepidation about National Tyre & Wheel's difficulty level of total liabilities, but we've got positives to focus on, too. To wit both its EBIT growth rate and conversion of EBIT to free cash flow were encouraging signs. Taking the abovementioned factors together we do think National Tyre & Wheel's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for National Tyre & Wheel (2 are significant) 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.