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. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. Above all, NORMA SE Group (ETR:NOEJ) is in debt. But should shareholders worry about its use of debt?
Why is debt risky?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. However, a more common (but still costly) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. Of course, many companies use debt to finance their growth, without any negative consequences. When we look at debt levels, we first consider cash and debt levels, together.
Check out our latest analysis for NORMA Group
What is the debt of the NORMA group?
The graph below, which you can click on for more details, shows that NORMA Group had a debt of 491.7 million euros in December 2021; about the same as the previous year. However, because it has a cash reserve of €185.7 million, its net debt is lower, at approximately €306.0 million.
How strong is the NORMA group’s balance sheet?
We can see from the most recent balance sheet that the NORMA group had liabilities of €333.3m due within one year, and liabilities of €496.4m due beyond . On the other hand, it had €185.7 million in cash and €169.5 million in receivables at less than one year. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables by €474.4 million.
This deficit is considerable compared to its market capitalization of 739.2 million euros, so it suggests that shareholders monitor the use of debt by NORMA Group. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet quickly.
We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). 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 ).
We would say that NORMA Group’s moderate net debt to EBITDA ratio (2.0) is indicative of leverage caution. And its towering EBIT of 10.3 times its interest expense means that the debt burden is as light as a peacock feather. Importantly, NORMA Group has increased its EBIT by 86% over the last twelve months, and this growth will make it easier to manage its debt. 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 NORMA Group’s ability to maintain a healthy balance sheet in the future. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
Finally, a company can only repay its debts with cash, not book profits. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, NORMA Group has generated free cash flow of a very strong 85% of its EBIT, more than we expected. This positions him well to pay off debt if desired.
Our point of view
Fortunately, NORMA Group’s impressive EBIT to free cash flow conversion means it has the upper hand on its debt. But truth be told, we think his total passive level undermines that impression a bit. When we consider the range of factors above, it appears that NORMA Group is quite sensitive with its use of debt. While this carries some risk, it can also improve shareholder returns. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks reside on the balance sheet, far from it. Know that NORMA Group shows 3 warning signs in our investment analysis you should know…
If you are interested in investing in companies that can generate profits without the burden of debt, then check out this free list of growing companies that have net cash on the balance sheet.
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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.