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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that New Jersey Resources Corporation (NYSE:NJR) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is New Jersey Resources's Debt?
The image below, which you can click on for greater detail, shows that at June 2022 New Jersey Resources had debt of US$2.89b, up from US$2.40b in one year. Net debt is about the same, since the it doesn't have much cash.
How Healthy Is New Jersey Resources' Balance Sheet?
Zooming in on the latest balance sheet data, we can see that New Jersey Resources had liabilities of US$969.4m due within 12 months and liabilities of US$3.42b due beyond that. On the other hand, it had cash of US$27.7m and US$274.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$4.09b.
Given this deficit is actually higher than the company's market capitalization of US$4.06b, we think shareholders really should watch New Jersey Resources's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
New Jersey Resources has a rather high debt to EBITDA ratio of 6.3 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 4.2 times, suggesting it can responsibly service its obligations. Notably, New Jersey Resources's EBIT was pretty flat over the last year, which isn't ideal given the debt load. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if New Jersey Resources can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, New Jersey Resources saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Our View
On the face of it, New Jersey Resources's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to grow its EBIT isn't such a worry. It's also worth noting that New Jersey Resources is in the Gas Utilities industry, which is often considered to be quite defensive. We're quite clear that we consider New Jersey Resources to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with New Jersey Resources (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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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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