Is Nordwest Handel (FRA:NWX) A Risky Investment?

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Nordwest Handel AG (FRA:NWX) does carry debt. But is this debt a concern to shareholders?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out the opportunities and risks within the DE Trade Distributors industry.

How Much Debt Does Nordwest Handel Carry?

The image below, which you can click on for greater detail, shows that at June 2022 Nordwest Handel had debt of €36.6m, up from €17.7m in one year. On the flip side, it has €6.60m in cash leading to net debt of about €30.0m.

How Healthy Is Nordwest Handel's Balance Sheet?

We can see from the most recent balance sheet that Nordwest Handel had liabilities of €393.3m falling due within a year, and liabilities of €22.2m due beyond that. Offsetting these obligations, it had cash of €6.60m as well as receivables valued at €420.9m due within 12 months. So it can boast €12.0m more liquid assets than total liabilities.

This excess liquidity suggests that Nordwest Handel is taking a careful approach to debt. Due to its strong net asset position, it is not likely to face issues 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Nordwest Handel's net debt to EBITDA ratio of about 1.7 suggests only moderate use of debt. And its strong interest cover of 14.2 times, makes us even more comfortable. It is well worth noting that Nordwest Handel's EBIT shot up like bamboo after rain, gaining 36% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Nordwest Handel will need earnings to service that debt. 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. During the last three years, Nordwest Handel burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Nordwest Handel's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. When we consider the range of factors above, it looks like Nordwest Handel is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. When analysing debt levels, the balance sheet is the obvious place to start. 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 Nordwest Handel (including 1 which is a bit unpleasant) .

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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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.