Is Mercury NZ (NZSE:MCY) A Risky Investment?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 note that Mercury NZ Limited (NZSE:MCY) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

See our latest analysis for Mercury NZ

What Is Mercury NZ's Net Debt?

As you can see below, Mercury NZ had NZ$1.92b of debt, at June 2023, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has NZ$86.0m in cash leading to net debt of about NZ$1.84b.

A Look At Mercury NZ's Liabilities

The latest balance sheet data shows that Mercury NZ had liabilities of NZ$952.0m due within a year, and liabilities of NZ$3.62b falling due after that. Offsetting this, it had NZ$86.0m in cash and NZ$472.0m in receivables that were due within 12 months. So it has liabilities totalling NZ$4.01b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Mercury NZ has a market capitalization of NZ$8.51b, 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).

Mercury NZ's net debt is sitting at a very reasonable 2.3 times its EBITDA, while its EBIT covered its interest expense just 4.9 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. It is well worth noting that Mercury NZ's EBIT shot up like bamboo after rain, gaining 66% in the last twelve months. That'll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Mercury NZ's ability to maintain a healthy balance sheet going forward. 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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Mercury NZ produced sturdy free cash flow equating to 51% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Happily, Mercury NZ's impressive EBIT growth rate implies it has the upper hand on its debt. But truth be told we feel its level of total liabilities does undermine this impression a bit. We would also note that Electric Utilities industry companies like Mercury NZ commonly do use debt without problems. Looking at all the aforementioned factors together, it strikes us that Mercury NZ can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. For example, we've discovered 3 warning signs for Mercury NZ (1 is a bit concerning!) that you should be aware of before investing here.

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.