Mercury NZ (NZSE:MCY) Seems To Use Debt Quite Sensibly

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. As with many other companies Mercury NZ Limited (NZSE:MCY) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Mercury NZ

What Is Mercury NZ's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 Mercury NZ had NZ$1.28b of debt, an increase on NZ$1.18b, over one year. However, it does have NZ$91.0m in cash offsetting this, leading to net debt of about NZ$1.19b.

How Strong Is Mercury NZ's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Mercury NZ had liabilities of NZ$914.0m due within 12 months and liabilities of NZ$2.18b due beyond that. On the other hand, it had cash of NZ$91.0m and NZ$230.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by NZ$2.78b.

Mercury NZ has a market capitalization of NZ$8.17b, 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).

Mercury NZ has net debt worth 2.4 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 6.6 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Also relevant is that Mercury NZ has grown its EBIT by a very respectable 21% in the last year, thus enhancing its ability to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Mercury NZ 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 we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Mercury NZ recorded free cash flow of 43% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

When it comes to the balance sheet, the standout positive for Mercury NZ was the fact that it seems able to grow its EBIT confidently. But the other factors we noted above weren't so encouraging. For example, its net debt to EBITDA makes us a little nervous about its debt. It's also worth noting that Mercury NZ is in the Electric Utilities industry, which is often considered to be quite defensive. When we consider all the elements mentioned above, it seems to us that Mercury NZ is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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 Mercury NZ is showing 2 warning signs in our investment analysis , and 1 of those is a bit unpleasant...

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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This article by Simply Wall St is general in nature. 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.
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