Does Napatech (OB:NAPA) Have A Healthy Balance Sheet?

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 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 Napatech A/S (OB:NAPA) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Napatech

What Is Napatech's Net Debt?

The image below, which you can click on for greater detail, shows that Napatech had debt of kr.10.0m at the end of March 2021, a reduction from kr.31.9m over a year. But on the other hand it also has kr.40.8m in cash, leading to a kr.30.8m net cash position.

A Look At Napatech's Liabilities

The latest balance sheet data shows that Napatech had liabilities of kr.31.8m due within a year, and liabilities of kr.12.7m falling due after that. On the other hand, it had cash of kr.40.8m and kr.28.3m worth of receivables due within a year. So it actually has kr.24.5m more liquid assets than total liabilities.

This surplus suggests that Napatech has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Napatech has more cash than debt is arguably a good indication that it can manage its debt safely.

It was also good to see that despite losing money on the EBIT line last year, Napatech turned things around in the last 12 months, delivering and EBIT of kr.17m. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Napatech 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. Napatech 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. During the last year, Napatech generated free cash flow amounting to a very robust 84% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing up

While it is always sensible to investigate a company's debt, in this case Napatech has kr.30.8m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of kr.15m, being 84% of its EBIT. So we don't think Napatech's use of debt is risky. 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 1 warning sign for Napatech 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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