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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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Nufarm Limited (ASX:NUF) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
Check out our latest analysis for Nufarm
What Is Nufarm's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of January 2019 Nufarm had AU$1.90b of debt, an increase on AU$936.2m, over one year. On the flip side, it has AU$340.1m in cash leading to net debt of about AU$1.56b.
A Look At Nufarm's Liabilities
Zooming in on the latest balance sheet data, we can see that Nufarm had liabilities of AU$1.87b due within 12 months and liabilities of AU$1.67b due beyond that. On the other hand, it had cash of AU$340.1m and AU$1.52b worth of receivables due within a year. So its liabilities total AU$1.68b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of AU$1.96b, so it does suggest shareholders should keep an eye on Nufarm's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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).
While Nufarm's debt to EBITDA ratio (4.6) suggests that it uses some debt, its interest cover is very weak, at 1.9, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Even worse, Nufarm saw its EBIT tank 22% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Nufarm's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.