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.' 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. We can see that Norsk Hydro ASA (OB:NHY) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Norsk Hydro Carry?
The image below, which you can click on for greater detail, shows that at December 2020 Norsk Hydro had debt of kr26.3b, up from kr21.2b in one year. However, it does have kr22.2b in cash offsetting this, leading to net debt of about kr4.12b.
A Look At Norsk Hydro's Liabilities
The latest balance sheet data shows that Norsk Hydro had liabilities of kr29.0b due within a year, and liabilities of kr57.9b falling due after that. On the other hand, it had cash of kr22.2b and kr18.4b worth of receivables due within a year. So it has liabilities totalling kr46.4b more than its cash and near-term receivables, combined.
Norsk Hydro has a very large market capitalization of kr109.2b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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).
While Norsk Hydro's low debt to EBITDA ratio of 0.34 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.4 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Notably, Norsk Hydro's EBIT launched higher than Elon Musk, gaining a whopping 826% on last year. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Norsk Hydro 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, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Norsk Hydro recorded free cash flow worth a fulsome 92% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
Happily, Norsk Hydro's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And the good news does not stop there, as its EBIT growth rate also supports that impression! Zooming out, Norsk Hydro seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. 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. Be aware that Norsk Hydro is showing 3 warning signs in our investment analysis , you should know about...
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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