Is Novozymes (CPH:NZYM B) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Novozymes A/S (CPH:NZYM B) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Novozymes

What Is Novozymes's Debt?

The image below, which you can click on for greater detail, shows that at March 2021 Novozymes had debt of kr.5.94b, up from kr.5.13b in one year. However, it also had kr.1.06b in cash, and so its net debt is kr.4.87b.

How Healthy Is Novozymes' Balance Sheet?

We can see from the most recent balance sheet that Novozymes had liabilities of kr.5.05b falling due within a year, and liabilities of kr.5.85b due beyond that. Offsetting this, it had kr.1.06b in cash and kr.3.47b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by kr.6.37b.

Since publicly traded Novozymes shares are worth a very impressive total of kr.125.0b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Novozymes has a low net debt to EBITDA ratio of only 1.0. And its EBIT easily covers its interest expense, being 74.1 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, Novozymes saw its EBIT drop by 2.2% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. 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 Novozymes 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, 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. During the last three years, Novozymes produced sturdy free cash flow equating to 75% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Novozymes'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, on a more sombre note, we are a little concerned by its EBIT growth rate. Zooming out, Novozymes seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for Novozymes that you should be aware of before investing here.

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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