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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. We can see that Nuance Communications, Inc. (NASDAQ:NUAN) does use debt in its business. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Nuance Communications’s Net Debt?
As you can see below, Nuance Communications had US$1.91b of debt at March 2019, down from US$2.31b a year prior. However, it also had US$620.7m in cash, and so its net debt is US$1.29b.
How Healthy Is Nuance Communications’s Balance Sheet?
According to the last reported balance sheet, Nuance Communications had liabilities of US$607.8m due within 12 months, and liabilities of US$2.48b due beyond 12 months. Offsetting these obligations, it had cash of US$620.7m as well as receivables valued at US$352.4m due within 12 months. So it has liabilities totalling US$2.12b more than its cash and near-term receivables, combined.
Nuance Communications has a market capitalization of US$4.77b, so it could very likely ameliorate its balance sheet if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. Because it carries more debt than cash, we think it’s worth watching Nuance Communications’s balance sheet over time.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While we wouldn’t blink an eye at Nuance Communications’s net debt to EBITDA ratio of 3.08, we think its super-low interest cover of 1.93 times is a bad sign. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. The silver lining is that Nuance Communications grew its EBIT by 181% last year, which nourishing like the idealism of youth. If that earnings trend continues it will make its debt load much more manageable in the future. 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 Nuance Communications 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Nuance Communications actually produced more free cash flow than EBIT over the last three years. There’s nothing better than incoming cash when it comes to staying in your lenders’ good graces.
The good news is that Nuance Communications’s demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But we must concede we find its interest cover has the opposite effect. All these things considered, it appears that Nuance Communications can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it’s worth monitoring the balance sheet. Of course, we wouldn’t say no to the extra confidence that we’d gain if we knew that Nuance Communications insiders have been buying shares: if you’re on the same wavelength, you can find out if insiders are buying by clicking this link.
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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