Is Nordwest Handel (FRA:NWX) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We note that Nordwest Handel AG (FRA:NWX) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Nordwest Handel

What Is Nordwest Handel's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2021 Nordwest Handel had €20.1m of debt, an increase on €14.6m, over one year. However, it also had €3.52m in cash, and so its net debt is €16.6m.

How Strong Is Nordwest Handel's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Nordwest Handel had liabilities of €319.4m due within 12 months and liabilities of €22.2m due beyond that. Offsetting these obligations, it had cash of €3.52m as well as receivables valued at €349.9m due within 12 months. So it actually has €11.8m 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.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Nordwest Handel has net debt of just 1.2 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 8.4 times the interest expense over the last year. Another good sign is that Nordwest Handel has been able to increase its EBIT by 27% in twelve months, making it easier to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Nordwest Handel recorded free cash flow of 39% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Nordwest Handel's EBIT growth rate suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its level of total liabilities is also very heartening. Zooming out, Nordwest Handel seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. When analysing debt levels, the balance sheet is the obvious place to start. 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.

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. 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.