The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. As with many other companies N2N Connect Berhad (KLSE:N2N) makes use of debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
See our latest analysis for N2N Connect Berhad
What Is N2N Connect Berhad's Net Debt?
As you can see below, N2N Connect Berhad had RM16.7m of debt at June 2020, down from RM25.3m a year prior. However, its balance sheet shows it holds RM131.6m in cash, so it actually has RM114.9m net cash.
How Strong Is N2N Connect Berhad's Balance Sheet?
We can see from the most recent balance sheet that N2N Connect Berhad had liabilities of RM31.9m falling due within a year, and liabilities of RM15.3m due beyond that. Offsetting this, it had RM131.6m in cash and RM37.7m in receivables that were due within 12 months. So it can boast RM122.0m more liquid assets than total liabilities.
This luscious liquidity implies that N2N Connect Berhad's 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 N2N Connect Berhad has more cash than debt is arguably a good indication that it can manage its debt safely.
Another good sign is that N2N Connect Berhad has been able to increase its EBIT by 22% in twelve months, making it easier to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if N2N Connect Berhad 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While N2N Connect Berhad 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. Over the most recent three years, N2N Connect Berhad recorded free cash flow worth 59% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Summing up
While it is always sensible to investigate a company's debt, in this case N2N Connect Berhad has RM114.9m in net cash and a decent-looking balance sheet. And it impressed us with its EBIT growth of 22% over the last year. So is N2N Connect Berhad's debt a risk? It doesn't seem so to us. 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. For example, we've discovered 2 warning signs for N2N Connect Berhad that you should be aware of before investing here.
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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