Is NF Holdings (TYO:6864) 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. As with many other companies NF Holdings Corporation (TYO:6864) 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 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. 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 think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for NF Holdings

What Is NF Holdings's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 NF Holdings had JP¥2.28b of debt, an increase on JP¥1.88b, over one year. However, its balance sheet shows it holds JP¥7.58b in cash, so it actually has JP¥5.30b net cash.

How Healthy Is NF Holdings' Balance Sheet?

We can see from the most recent balance sheet that NF Holdings had liabilities of JP¥3.44b falling due within a year, and liabilities of JP¥2.01b due beyond that. Offsetting this, it had JP¥7.58b in cash and JP¥2.50b in receivables that were due within 12 months. So it actually has JP¥4.62b more liquid assets than total liabilities.

This luscious liquidity implies that NF Holdings' balance sheet is sturdy like a giant sequoia tree. On this view, lenders should feel as safe as the beloved of a black-belt karate master. Simply put, the fact that NF Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.

In fact NF Holdings's saving grace is its low debt levels, because its EBIT has tanked 22% 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. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since NF Holdings 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. While NF Holdings has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Looking at the most recent three years, NF Holdings recorded free cash flow of 42% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing up

While it is always sensible to investigate a company's debt, in this case NF Holdings has JP¥5.30b in net cash and a decent-looking balance sheet. So we are not troubled with NF Holdings's debt use. 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. Case in point: We've spotted 1 warning sign for NF Holdings you should be aware of.

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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