Is NORMA Group (ETR:NOEJ) Using Too Much Debt?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. Importantly, NORMA Group SE (ETR:NOEJ) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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.

Check out our latest analysis for NORMA Group

What Is NORMA Group's Net Debt?

The image below, which you can click on for greater detail, shows that NORMA Group had debt of €533.6m at the end of September 2020, a reduction from €592.1m over a year. However, because it has a cash reserve of €203.1m, its net debt is less, at about €330.4m.

How Strong Is NORMA Group's Balance Sheet?

According to the last reported balance sheet, NORMA Group had liabilities of €302.3m due within 12 months, and liabilities of €555.9m due beyond 12 months. Offsetting these obligations, it had cash of €203.1m as well as receivables valued at €161.8m due within 12 months. So its liabilities total €493.3m more than the combination of its cash and short-term receivables.

NORMA Group has a market capitalization of €1.31b, so it could very likely raise cash to ameliorate 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

NORMA Group has a debt to EBITDA ratio of 3.4 and its EBIT covered its interest expense 2.9 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Worse, NORMA Group's EBIT was down 67% 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. 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 NORMA Group can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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, NORMA Group generated free cash flow amounting to a very robust 94% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

NORMA Group's EBIT growth rate and interest cover definitely weigh on it, in our esteem. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that NORMA Group is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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 4 warning signs we've spotted with NORMA Group (including 1 which makes us a bit uncomfortable) .

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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