Nextcom (TLV:NXTM) Could Easily Take On More Debt

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. As with many other companies Nextcom Ltd. (TLV:NXTM) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Nextcom

How Much Debt Does Nextcom Carry?

The image below, which you can click on for greater detail, shows that at December 2020 Nextcom had debt of ₪73.3m, up from ₪61.5m in one year. However, it does have ₪71.6m in cash offsetting this, leading to net debt of about ₪1.70m.

How Healthy Is Nextcom's Balance Sheet?

We can see from the most recent balance sheet that Nextcom had liabilities of ₪133.9m falling due within a year, and liabilities of ₪55.2m due beyond that. On the other hand, it had cash of ₪71.6m and ₪134.6m worth of receivables due within a year. So it can boast ₪17.2m more liquid assets than total liabilities.

This short term liquidity is a sign that Nextcom could probably pay off its debt with ease, as its balance sheet is far from stretched. Carrying virtually no net debt, Nextcom has a very light debt load indeed.

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). 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).

With net debt at just 0.059 times EBITDA, it seems Nextcom only uses a little bit of leverage. But EBIT was only 6.0 times the interest expense last year, so the borrowing is clearly weighing on the business somewhat. Also relevant is that Nextcom has grown its EBIT by a very respectable 30% in the last year, thus enhancing its ability to pay down 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 Nextcom 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 it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Nextcom recorded free cash flow of 50% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Nextcom'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 the good news does not stop there, as its net debt to EBITDA also supports that impression! Looking at the bigger picture, we think Nextcom's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 3 warning signs we've spotted with Nextcom .

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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