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 can see that NEUCA S.A. (WSE:NEU) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is NEUCA's Debt?
As you can see below, NEUCA had zł180.4m of debt at March 2021, down from zł290.9m a year prior. However, it also had zł26.8m in cash, and so its net debt is zł153.5m.
A Look At NEUCA's Liabilities
According to the last reported balance sheet, NEUCA had liabilities of zł2.44b due within 12 months, and liabilities of zł295.2m due beyond 12 months. On the other hand, it had cash of zł26.8m and zł1.27b worth of receivables due within a year. So it has liabilities totalling zł1.44b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since NEUCA has a market capitalization of zł3.51b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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).
NEUCA has net debt of just 0.52 times EBITDA, suggesting it could ramp leverage without breaking a sweat. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. And we also note warmly that NEUCA grew its EBIT by 18% last year, making its debt load easier to handle. 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 NEUCA 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, NEUCA produced sturdy free cash flow equating to 60% 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.
Happily, NEUCA's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its net debt to EBITDA also supports that impression! We would also note that Healthcare industry companies like NEUCA commonly do use debt without problems. Taking all this data into account, it seems to us that NEUCA takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. 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. We've identified 1 warning sign with NEUCA , and understanding them should be part of your investment process.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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