Is National Tyre & Wheel (ASX:NTD) Using Too Much Debt?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. 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?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

View our latest analysis for National Tyre & Wheel

What Is National Tyre & Wheel's Debt?

As you can see below, National Tyre & Wheel had AU$93.8m of debt, at December 2022, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of AU$19.3m, its net debt is less, at about AU$74.5m.

How Healthy Is National Tyre & Wheel's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that National Tyre & Wheel had liabilities of AU$122.4m due within 12 months and liabilities of AU$138.9m due beyond that. Offsetting this, it had AU$19.3m in cash and AU$85.5m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$156.5m.

The deficiency here weighs heavily on the AU$71.3m 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'd watch its balance sheet closely, without a doubt. After all, National Tyre & Wheel would likely require a major re-capitalisation if it had to pay its creditors today.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While National Tyre & Wheel's debt to EBITDA ratio (4.1) suggests that it uses some debt, its interest cover is very weak, at 1.7, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Worse, National Tyre & Wheel's EBIT was down 62% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that 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 National Tyre & Wheel 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. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, National Tyre & Wheel recorded free cash flow worth 58% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

On the face of it, National Tyre & Wheel's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Taking into account all the aforementioned factors, it looks like National Tyre & Wheel has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 3 warning signs we've spotted with National Tyre & Wheel (including 1 which is a bit concerning) .

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.

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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.