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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Nera Telecommunications Ltd (SGX:N01) makes use of debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Nera Telecommunications's Net Debt?
The image below, which you can click on for greater detail, shows that at December 2020 Nera Telecommunications had debt of S$28.5m, up from S$16.5m in one year. However, because it has a cash reserve of S$23.0m, its net debt is less, at about S$5.48m.
A Look At Nera Telecommunications' Liabilities
According to the last reported balance sheet, Nera Telecommunications had liabilities of S$92.0m due within 12 months, and liabilities of S$4.12m due beyond 12 months. Offsetting this, it had S$23.0m in cash and S$120.5m in receivables that were due within 12 months. So it can boast S$47.4m more liquid assets than total liabilities.
This surplus strongly suggests that Nera Telecommunications has a rock-solid balance sheet (and the debt is of no concern whatsoever). With this in mind one could posit that its balance sheet means the company is able to handle some adversity.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Nera Telecommunications has net debt of just 0.95 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 8.7 times, which is more than adequate. On the other hand, Nera Telecommunications saw its EBIT drop by 4.3% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. There's no doubt that we learn most about debt from the balance sheet. But it is Nera Telecommunications's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
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, Nera Telecommunications recorded free cash flow of 21% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Nera Telecommunications's level of total liabilities suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. When we consider the range of factors above, it looks like Nera Telecommunications is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 4 warning signs for Nera Telecommunications you should be aware of, and 2 of them are concerning.
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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