Here's Why Neste Oyj (HEL:NESTE) Has A Meaningful Debt Burden

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.' 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 Neste Oyj (HEL:NESTE) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Neste Oyj

What Is Neste Oyj's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2023 Neste Oyj had €2.65b of debt, an increase on €2.11b, over one year. However, because it has a cash reserve of €1.04b, its net debt is less, at about €1.62b.

How Healthy Is Neste Oyj's Balance Sheet?

We can see from the most recent balance sheet that Neste Oyj had liabilities of €3.96b falling due within a year, and liabilities of €3.53b due beyond that. Offsetting this, it had €1.04b in cash and €1.91b in receivables that were due within 12 months. So it has liabilities totalling €4.55b more than its cash and near-term receivables, combined.

Of course, Neste Oyj has a titanic market capitalization of €25.5b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Neste Oyj has a low net debt to EBITDA ratio of only 0.80. And its EBIT easily covers its interest expense, being 23.1 times the size. So we're pretty relaxed about its super-conservative use of debt. In fact Neste Oyj's saving grace is its low debt levels, because its EBIT has tanked 45% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Neste Oyj can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Neste Oyj's free cash flow amounted to 34% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Neither Neste Oyj's ability to grow its EBIT nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Looking at all the angles mentioned above, it does seem to us that Neste Oyj is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. We've identified 3 warning signs with Neste Oyj , 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.