Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. We can see that Natural Alternatives International, Inc. (NASDAQ:NAII) does use debt in its business. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 think about a company's use of debt, we first look at cash and debt together.
What Is Natural Alternatives International's Net Debt?
As you can see below, Natural Alternatives International had US$10.0m of debt, at September 2021, which is about the same as the year before. You can click the chart for greater detail. But on the other hand it also has US$20.0m in cash, leading to a US$10.0m net cash position.
How Healthy Is Natural Alternatives International's Balance Sheet?
The latest balance sheet data shows that Natural Alternatives International had liabilities of US$20.6m due within a year, and liabilities of US$27.0m falling due after that. Offsetting these obligations, it had cash of US$20.0m as well as receivables valued at US$20.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$7.39m.
Since publicly traded Natural Alternatives International shares are worth a total of US$88.7m, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, Natural Alternatives International boasts net cash, so it's fair to say it does not have a heavy debt load!
Even more impressive was the fact that Natural Alternatives International grew its EBIT by 663% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Natural Alternatives International'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. Natural Alternatives International may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Natural Alternatives International burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
We could understand if investors are concerned about Natural Alternatives International's liabilities, but we can be reassured by the fact it has has net cash of US$10.0m. And we liked the look of last year's 663% year-on-year EBIT growth. So we are not troubled with Natural Alternatives International's debt use. 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. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for Natural Alternatives International (of which 2 are significant!) you should know about.
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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Natural Alternatives International
Natural Alternatives International, Inc. engages in formulating, manufacturing, and marketing nutritional supplements in the United States, Europe, Australia, Asia, Mexico, and Canada.
Excellent balance sheet and slightly overvalued.