Here's Why Norsk Hydro (OB:NHY) Can Manage Its Debt Responsibly

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.' 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 Norsk Hydro ASA (OB:NHY) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Norsk Hydro

What Is Norsk Hydro's Debt?

The image below, which you can click on for greater detail, shows that at December 2022 Norsk Hydro had debt of kr32.8b, up from kr25.3b in one year. However, its balance sheet shows it holds kr34.0b in cash, so it actually has kr1.20b net cash.

How Healthy Is Norsk Hydro's Balance Sheet?

We can see from the most recent balance sheet that Norsk Hydro had liabilities of kr42.8b falling due within a year, and liabilities of kr48.0b due beyond that. Offsetting these obligations, it had cash of kr34.0b as well as receivables valued at kr24.0b due within 12 months. So it has liabilities totalling kr32.9b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Norsk Hydro has a huge market capitalization of kr156.7b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, Norsk Hydro also has more cash than debt, so we're pretty confident it can manage its debt safely.

On top of that, Norsk Hydro grew its EBIT by 55% over the last twelve months, and that growth will make it easier to handle its debt. 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 Norsk Hydro 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Norsk Hydro may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Looking at the most recent three years, Norsk Hydro recorded free cash flow of 33% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Summing Up

While Norsk Hydro does have more liabilities than liquid assets, it also has net cash of kr1.20b. And we liked the look of last year's 55% year-on-year EBIT growth. So is Norsk Hydro's debt a risk? It doesn't seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 2 warning signs we've spotted with Norsk Hydro (including 1 which can't be ignored) .

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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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.