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The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 Nokian Renkaat Oyj (HEL:TYRES) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
See our latest analysis for Nokian Renkaat Oyj
What Is Nokian Renkaat Oyj's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Nokian Renkaat Oyj had €235.2m of debt, an increase on €134.4m, over one year. However, it also had €109.3m in cash, and so its net debt is €125.9m.
How Healthy Is Nokian Renkaat Oyj's Balance Sheet?
According to the last reported balance sheet, Nokian Renkaat Oyj had liabilities of €400.2m due within 12 months, and liabilities of €275.5m due beyond 12 months. Offsetting these obligations, it had cash of €109.3m as well as receivables valued at €731.2m due within 12 months. So it can boast €164.8m more liquid assets than total liabilities.
This short term liquidity is a sign that Nokian Renkaat Oyj could probably pay off its debt with ease, as its balance sheet is far from stretched.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).
Nokian Renkaat Oyj has a low debt to EBITDA ratio of only 0.27. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So there's no doubt this company can take on debt while staying cool as a cucumber. On the other hand, Nokian Renkaat Oyj saw its EBIT drop by 7.7% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. 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 Nokian Renkaat Oyj can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.