These 4 metrics indicate that NEXTDC (ASX:NXT) is using debt heavily

Howard Marks said it well when he said that, rather than worrying about stock price volatility, “the possibility of permanent loss is the risk I worry about…and that every practical investor that I know is worried”. 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. We note that NEXTDC Limited (ASX:NXT) has debt on its balance sheet. But should shareholders worry about its use of debt?

When is debt dangerous?

Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. By replacing dilution, however, debt can be a great tool for companies that need capital to invest in growth at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.

See our latest analysis for NEXTDC

What is NEXTDC’s debt?

The image below, which you can click on for more details, shows that in June 2022, NEXTDC had A$1.06 billion in debt, up from A$783.5 million in one year. However, since it has a cash reserve of A$456.6 million, its net debt is less, at around A$602.2 million.

How healthy is NEXTDC’s balance sheet?

Zooming in on the latest balance sheet data, we can see that NEXTDC had liabilities of A$104.3 million due within 12 months and liabilities of A$1.17 billion due beyond. On the other hand, it had cash of A$456.6 million and A$44.3 million of receivables due within a year. Thus, its liabilities total A$777.6 million more than the combination of its cash and short-term receivables.

Of course, NEXTDC has a market capitalization of A$4.25 billion, so those liabilities are probably manageable. That said, it is clear that we must continue to monitor its record, lest it deteriorate.

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). Thus, we consider debt to earnings with and without amortization and depreciation expense.

While we are not concerned about NEXTDC’s net debt to EBITDA ratio of 3.9, we believe its extremely low interest coverage of 1.1x is a sign of high leverage. It looks like the company is incurring significant amortization and amortization costs, so perhaps its leverage is heavier than it first appears, since EBITDA is arguably a generous metric. benefits. It seems clear that the cost of borrowing money is having a negative impact on shareholder returns lately. The good news is that NEXTDC has grown its EBIT smoothly by 54% over the last twelve months. Like a mother’s loving embrace of a newborn, this kind of growth builds resilience, putting the company in a stronger position to manage its debt. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether NEXTDC can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.

Finally, a company can only repay its debts with cold hard cash, not with book profits. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, NEXTDC has burned a lot of money. While investors no doubt expect a reversal of this situation in due course, it clearly means that its use of debt is more risky.

Our point of view

Neither NEXTDC’s ability to convert EBIT to free cash flow nor its interest coverage gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story and suggests some resilience. Looking at all the angles mentioned above, it seems to us that NEXTDC is a bit risky investment due to its leverage. Not all risk is bad, as it can increase stock price returns if it pays off, but this leverage risk is worth keeping in mind. 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. To this end, you should be aware of the 1 warning sign we spotted with NEXTDC.

In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.

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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.