Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. We note that Neochim AD (BUL:3NB) does have debt on its balance sheet. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. 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.
What Is Neochim AD's Debt?
The image below, which you can click on for greater detail, shows that Neochim AD had debt of лв6.01m at the end of September 2020, a reduction from лв25.2m over a year. But on the other hand it also has лв20.3m in cash, leading to a лв14.3m net cash position.
How Strong Is Neochim AD's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Neochim AD had liabilities of лв21.2m due within 12 months and liabilities of лв8.60m due beyond that. On the other hand, it had cash of лв20.3m and лв3.56m worth of receivables due within a year. So it has liabilities totalling лв5.94m more than its cash and near-term receivables, combined.
Since publicly traded Neochim AD shares are worth a total of лв64.1m, 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. Despite its noteworthy liabilities, Neochim AD boasts net cash, so it's fair to say it does not have a heavy debt load!
It was also good to see that despite losing money on the EBIT line last year, Neochim AD turned things around in the last 12 months, delivering and EBIT of лв11m. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Neochim AD 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Neochim AD 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. Happily for any shareholders, Neochim AD actually produced more free cash flow than EBIT over the last year. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Neochim AD has лв14.3m in net cash. And it impressed us with free cash flow of лв39m, being 353% of its EBIT. So is Neochim AD'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. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 1 warning sign we've spotted with Neochim AD .
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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