Is Norsk Hydro (OB:NHY) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Norsk Hydro ASA (OB:NHY) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Norsk Hydro

What Is Norsk Hydro's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2023 Norsk Hydro had kr35.0b of debt, an increase on kr28.9b, over one year. However, it does have kr23.6b in cash offsetting this, leading to net debt of about kr11.4b.

A Look At Norsk Hydro's Liabilities

We can see from the most recent balance sheet that Norsk Hydro had liabilities of kr40.4b falling due within a year, and liabilities of kr56.3b due beyond that. Offsetting these obligations, it had cash of kr23.6b as well as receivables valued at kr27.6b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by kr45.5b.

While this might seem like a lot, it is not so bad since Norsk Hydro has a huge market capitalization of kr119.6b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). 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).

Norsk Hydro's net debt is only 0.22 times its EBITDA. And its EBIT easily covers its interest expense, being 92.3 times the size. So we're pretty relaxed about its super-conservative use of debt. But the bad news is that Norsk Hydro has seen its EBIT plunge 16% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. When analysing debt levels, the balance sheet is the obvious place to start. 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 company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Norsk Hydro recorded free cash flow of 36% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

We feel some trepidation about Norsk Hydro's difficulty EBIT growth rate, but we've got positives to focus on, too. To wit both its interest cover and net debt to EBITDA were encouraging signs. We think that Norsk Hydro's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 2 warning signs we've spotted with Norsk Hydro .

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.