Nova Cannabis (TSE:NOVC) Has A Somewhat Strained Balance Sheet

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.' 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 note that Nova Cannabis Inc. (TSE:NOVC) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. 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.

See our latest analysis for Nova Cannabis

What Is Nova Cannabis's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 Nova Cannabis had CA$14.4m of debt, an increase on CA$9.77m, over one year. On the flip side, it has CA$10.9m in cash leading to net debt of about CA$3.56m.

A Look At Nova Cannabis' Liabilities

The latest balance sheet data shows that Nova Cannabis had liabilities of CA$28.0m due within a year, and liabilities of CA$43.7m falling due after that. On the other hand, it had cash of CA$10.9m and CA$4.42m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$56.4m.

Given this deficit is actually higher than the company's market capitalization of CA$54.9m, we think shareholders really should watch Nova Cannabis's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Given net debt is only 0.32 times EBITDA, it is initially surprising to see that Nova Cannabis's EBIT has low interest coverage of 1.6 times. So while we're not necessarily alarmed we think that its debt is far from trivial. Notably, Nova Cannabis made a loss at the EBIT level, last year, but improved that to positive EBIT of CA$6.6m in the last twelve months. 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 Nova Cannabis 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, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Nova Cannabis recorded free cash flow worth a fulsome 86% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

While Nova Cannabis's interest cover has us nervous. For example, its conversion of EBIT to free cash flow and net debt to EBITDA give us some confidence in its ability to manage its debt. We think that Nova Cannabis's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. The balance sheet is clearly the area to focus on when you are analysing debt. 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 Nova Cannabis (including 1 which doesn't sit too well with us) .

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.