Here's Why Nordwest Handel (FRA:NWX) Can Manage Its Debt Responsibly

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. Importantly, Nordwest Handel AG (FRA:NWX) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Nordwest Handel

How Much Debt Does Nordwest Handel Carry?

As you can see below, Nordwest Handel had €14.6m of debt at September 2020, down from €20.0m a year prior. However, it does have €8.30m in cash offsetting this, leading to net debt of about €6.31m.

How Strong Is Nordwest Handel's Balance Sheet?

The latest balance sheet data shows that Nordwest Handel had liabilities of €240.7m due within a year, and liabilities of €24.9m falling due after that. Offsetting these obligations, it had cash of €8.30m as well as receivables valued at €267.9m due within 12 months. So it can boast €10.6m more liquid assets than total liabilities.

This excess liquidity suggests that Nordwest Handel is taking a careful approach to debt. Because it has plenty of assets, it is unlikely to have trouble with its lenders.

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). 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).

While Nordwest Handel's low debt to EBITDA ratio of 0.54 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.7 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Fortunately, Nordwest Handel grew its EBIT by 2.8% in the last year, making that debt load look even more manageable. There's no doubt that we learn most about debt from the balance sheet. But it is Nordwest Handel's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Considering the last three years, Nordwest Handel actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Based on what we've seen Nordwest Handel is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its net debt to EBITDA. When we consider all the elements mentioned above, it seems to us that Nordwest Handel is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. We've identified 2 warning signs with Nordwest Handel , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

If you’re looking to trade Nordwest Handel, open an account with the lowest-cost* platform trusted by professionals, Interactive Brokers. Their clients from over 200 countries and territories trade stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted

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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.