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.' 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 note that Norwegian Cruise Line Holdings Ltd. (NYSE:NCLH) does have debt on its balance sheet. 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is Norwegian Cruise Line Holdings's Net Debt?
As you can see below, Norwegian Cruise Line Holdings had US$6.54b of debt, at March 2019, which is about the same the year before. You can click the chart for greater detail. However, because it has a cash reserve of US$305.2m, its net debt is less, at about US$6.24b.
How Strong Is Norwegian Cruise Line Holdings's Balance Sheet?
According to the last reported balance sheet, Norwegian Cruise Line Holdings had liabilities of US$3.43b due within 12 months, and liabilities of US$6.43b due beyond 12 months. On the other hand, it had cash of US$305.2m and US$57.1m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$9.49b.
This is a mountain of leverage even relative to its gargantuan market capitalization of US$10.6b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Norwegian Cruise Line Holdings has a debt to EBITDA ratio of 3.4 and its EBIT covered its interest expense 4.5 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. One way Norwegian Cruise Line Holdings could vanquish its debt would be if it stops borrowing more but conitinues to grow EBIT at around 10%, as it did over the last year. 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 Norwegian Cruise Line Holdings 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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Norwegian Cruise Line Holdings recorded free cash flow of 31% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
On this analysis Norwegian Cruise Line Holdings's level of total liabilities and net debt to EBITDA both make us a little nervous. But the good news is that its solid EBIT growth rate gives us reason for some optimism. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Norwegian Cruise Line Holdings stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. Given our hesitation about the stock, it would be good to know if Norwegian Cruise Line Holdings insiders have sold any shares recently. You click here to find out if insiders have sold recently.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.