Does Nemak S. A. B. de C. V (BMV:NEMAKA) Have A Healthy Balance Sheet?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Nemak, S. A. B. de C. V. (BMV:NEMAKA) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Nemak S. A. B. de C. V

How Much Debt Does Nemak S. A. B. de C. V Carry?

The image below, which you can click on for greater detail, shows that Nemak S. A. B. de C. V had debt of Mex$31.6b at the end of September 2021, a reduction from Mex$43.9b over a year. However, it does have Mex$4.27b in cash offsetting this, leading to net debt of about Mex$27.4b.

How Strong Is Nemak S. A. B. de C. V's Balance Sheet?

The latest balance sheet data shows that Nemak S. A. B. de C. V had liabilities of Mex$31.6b due within a year, and liabilities of Mex$31.2b falling due after that. Offsetting these obligations, it had cash of Mex$4.27b as well as receivables valued at Mex$10.1b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by Mex$48.5b.

The deficiency here weighs heavily on the Mex$18.2b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Nemak S. A. B. de C. V would likely require a major re-capitalisation if it had to pay its creditors today.

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.

Nemak S. A. B. de C. V has net debt worth 2.5 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 2.7 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Pleasingly, Nemak S. A. B. de C. V is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 141% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Nemak S. A. B. de C. V's ability to maintain a healthy balance sheet going forward. 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Nemak S. A. B. de C. V produced sturdy free cash flow equating to 59% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Neither Nemak S. A. B. de C. V's ability to handle its total liabilities nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. When we consider all the factors discussed, it seems to us that Nemak S. A. B. de C. V is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. Be aware that Nemak S. A. B. de C. V is showing 2 warning signs in our investment analysis , and 1 of those is potentially serious...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.