Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. Like many other companies Nick Scali Limited (ASX:NCK) uses debt. But does this debt worry shareholders?
When is debt dangerous?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. If things go really bad, lenders can take over the business. However, a more frequent (but still costly) event is when a company has to issue shares at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. When we look at debt levels, we first consider cash and debt levels, together.
Check out our latest analysis for Nick Scali
How much debt does Nick Scali carry?
You can click on the graph below for historical figures, but it shows that in December 2021, Nick Scali had A$96.2 million in debt, an increase from A$33.7 million, over a year. However, he also had A$60.6 million in cash, so his net debt is A$35.6 million.
How strong is Nick Scali’s balance sheet?
Zooming in on the latest balance sheet data, we can see that Nick Scali had liabilities of A$175.8m due within 12 months and liabilities of A$288.1m due beyond. In compensation for these obligations, it had liquid assets of 60.6 million Australian dollars as well as receivables valued at 4.39 million Australian dollars maturing within 12 months. It therefore has liabilities totaling A$398.9 million more than its cash and short-term receivables, combined.
This shortfall is not that bad as Nick Scali is worth A$691.7 million and therefore could probably raise enough capital to shore up his balance sheet, should the need arise. But we definitely want to keep our eyes peeled for indications that its debt is too risky.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
Nick Scali has a low net debt to EBITDA ratio of just 0.28. And its EBIT covers its interest charges 16.6 times. One could therefore say that he is no more threatened by his debt than an elephant is by a mouse. On top of that, we are happy to report that Nick Scali has increased his EBIT by 47%, reducing the specter of future debt repayments. There is no doubt that we learn the most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Nick Scali’s ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Nick Scali has actually produced more free cash flow than EBIT. There’s nothing better than incoming money to stay in the good books of your lenders.
Our point of view
The good news is that Nick Scali’s demonstrated ability to cover his interest costs with his EBIT delights us like a fluffy puppy does a toddler. But truth be told, we think his total passive level undermines that impression a bit. Zooming out, Nick Scali seems to be using debt quite sensibly; and that gets the green light from us. Although debt carries risks, when used wisely, it can also generate a higher return on equity. The balance sheet is clearly the area to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist outside of the balance sheet. These risks can be difficult to spot. Every business has them, and we’ve spotted 2 warning signs for Nick Scali you should know.
In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeat present.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.