Is North West (TSE:NWC) A Risky Investment?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, The North West Company Inc. (TSE:NWC) does carry debt. But is this debt a concern to shareholders?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for North West

How Much Debt Does North West Carry?

The image below, which you can click on for greater detail, shows that North West had debt of CA$281.4m at the end of January 2021, a reduction from CA$411.0m over a year. However, it does have CA$71.5m in cash offsetting this, leading to net debt of about CA$209.9m.

How Strong Is North West's Balance Sheet?

According to the last reported balance sheet, North West had liabilities of CA$315.1m due within 12 months, and liabilities of CA$370.8m due beyond 12 months. Offsetting these obligations, it had cash of CA$71.5m as well as receivables valued at CA$91.4m due within 12 months. So it has liabilities totalling CA$523.0m more than its cash and near-term receivables, combined.

This deficit isn't so bad because North West is worth CA$1.78b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).

North West's net debt is only 0.72 times its EBITDA. And its EBIT easily covers its interest expense, being 14.4 times the size. So we're pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that North West grew its EBIT by 104% over twelve months. 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 ultimately the future profitability of the business will decide if North West 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, North West generated free cash flow amounting to a very robust 80% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

Happily, North West's impressive interest cover implies it has the upper hand on its debt. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Considering this range of factors, it seems to us that North West is quite prudent with its debt, and the risks seem well managed. So the balance sheet looks pretty healthy, 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. Be aware that North West is showing 3 warning signs in our investment analysis , you should know about...

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. 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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