Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘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 Neo Performance Materials Inc. ( TSE:NEO ) does use debt in its business. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company’s use of debt, we first look at cash and debt together.
Check out our latest analysis for Neo Performance Materials
What Is Neo Performance Materials’s Net Debt?
The image below, which you can click on for greater detail, shows that at June 2022 Neo Performance Materials had debt of US$16.5m, up from US$4.42m in one year. But it also has US$66.2m in cash to offset that, meaning it has US$49.7m net cash.
How Strong Is Neo Performance Materials’ Balance Sheet?
We can see from the most recent balance sheet that Neo Performance Materials had liabilities of US$106.1m falling due within a year, and liabilities of US$45.9m due beyond that. Offsetting these obligations, it had cash of US$66.2m as well as receivables valued at US$86.3m due within 12 months. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.
Having regard to Neo Performance Materials’ size, it seems that its liquid assets are well balanced with its total liabilities. So while it’s hard to imagine that the US$423.1m company is struggling for cash, we still think it’s worth monitoring its balance sheet. Succinctly put, Neo Performance Materials boasts net cash, so it’s fair to say it does not have a heavy debt load!
In addition to that, we’re happy to report that Neo Performance Materials has boosted its EBIT by 79%, thus reducing the spectre of future debt repayments. 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 Neo Performance Materials 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 .
Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Neo Performance Materials has net cash on its balance sheet, it’s still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Neo Performance Materials reported free cash flow worth 7.1% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
Summing Up
While it is always sensible to investigate a company’s debt, in this case Neo Performance Materials has US$49.7m in net cash and a decent-looking balance sheet. And it impressed us with its EBIT growth of 79% over the last year. So we don’t think Neo Performance Materials’s use of debt is risky. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We’ve identified 4 warning signs with Neo Performance Materials (at least 2 which are significant) , and understanding them should be part of your investment process.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet .
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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