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. Importantly, NP3 Fastigheter AB (publ) (STO:NP3) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is NP3 Fastigheter's Debt?
As you can see below, at the end of March 2021, NP3 Fastigheter had kr7.86b of debt, up from kr7.08b a year ago. Click the image for more detail. On the flip side, it has kr304.0m in cash leading to net debt of about kr7.55b.
How Strong Is NP3 Fastigheter's Balance Sheet?
According to the last reported balance sheet, NP3 Fastigheter had liabilities of kr564.0m due within 12 months, and liabilities of kr8.43b due beyond 12 months. On the other hand, it had cash of kr304.0m and kr47.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by kr8.64b.
This is a mountain of leverage relative to its market capitalization of kr8.97b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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).
NP3 Fastigheter has a rather high debt to EBITDA ratio of 9.6 which suggests a meaningful debt load. However, its interest coverage of 4.2 is reasonably strong, which is a good sign. On a slightly more positive note, NP3 Fastigheter grew its EBIT at 13% over the last year, further increasing its ability to manage 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 NP3 Fastigheter 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, NP3 Fastigheter recorded free cash flow worth 64% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
NP3 Fastigheter's net debt to EBITDA was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its conversion of EBIT to free cash flow is relatively strong. When we consider all the factors discussed, it seems to us that NP3 Fastigheter is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 4 warning signs with NP3 Fastigheter (at least 2 which don't sit too well with us) , and understanding them should be part of your investment process.
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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